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Kevin Cook

GOOG Earnings: What's the Probability of a $60 Surge?

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Monster of the web, Google (GOOG), reports earnings Thursday after the market close with consensus EPS expectations at $7.59. After their second quarter report in July, which handed investors a 13% upside earnings surprise, the stock gapped higher by $70 from $530 to $600, also a 13% jump.

The last time GOOG did something similar was in the third quarter of 2010 when it beat earnings estimates by 13.5% and the stock made a $60 pop from $540 to $600. I recommended an options trade a month before that report, for my subscribers then at TheStreet.com, to buy the January 2011 450/500 call spread for $25, resulting in a very quick profit of nearly 100%.

Since GOOG continues to innovate and dominate, betting on its upside surprises -- especially when the stock is fairly valued -- works out better than planning for its disappointments.

But they have been known to miss occasionally too. After their first quarter report in April when they fell short of the consensus number by 10 cents (1.4%), the stock dropped $50 (8.6%) from $580 to $530 the day after.

GOOG was already getting swamped with a wave of institutional liquidation as earnings expectations had started to flatten out earlier in the year and the stock could not get through resistance around $630-40 on three tries.

But it eventually found support at $475 as portfolio managers saw a company with over $30 billion in revenues, expected profits of $9.5 billion this year, and a forward P/E multiple of under 18 times. This led to the price vault we saw in July which took shares back up above $620.

What's In Store This Week?

One great way to get an idea of what kind of earnings surprise might be in store for a stock is to look at its options volatility. Professional option market makers in Google stock have gotten pretty good at pricing-in the most likely expectations through what they are willing to pay for at-the-money (ATM) calls and puts. We'll look at that view in a moment.

First, we want to know what the earnings estimate picture says. Below is a the hard data that shows where the analyst community is at on GOOG.

Note: the Zacks EPS estimate data includes Employee Stock Option expense, whereas many "street" estimates do not. The consensus EPS estimate excluding ESO is $8.75, with a high/low of $9.15/$8.09. Use caution when reading the company report or press release to be sure you are comparing "apples to apples."

The top table of Detailed Earnings Estimates has a few data points worth noting. The Most Recent Consensus for the current quarter of $7.83 is akin to the "whisper number" you might start to hear. That 24 cent difference vs. the $7.59 consensus would only represent a 3% beat. And this means that this is where the bar probably is for any beat at all.

The Zacks Most Accurate Estimate is currently at $7.76 (a proprietary number not shown in this table), so this is probably the lowest bar for a beat. And with the high estimate at $7.90, it doesn't seem like we should be expecting a blow-out quarter. Then again, if they do crush this number, $600 here we come!

Finally, the estimates for the fourth quarter at $8.84, and next year at $36.86, will be a big focus for large investors in the stock. They want to see the double-digit growth trajectory in the mid-teens be maintained and not falter. And they will be digging through the company's revenue numbers and recent investment decisions, like buying Motorola Mobility to build a moat around its phone business, to determine that.

The middle table of Estimate Revisions has a minor mixed tone with 1 analyst raising estimates and 1 lowering them.

The bottom table portraying the Consensus Estimate Trend is one of my favorite because it gives you such an instant snapshot of which direction analysts are headed. As you can see, estimates made a big jump across the board after the April report when GOOG not only crushed its numbers, with 54% of revenues coming from overseas, but revealed all sorts of exciting new ventures and projects that it was sure to dominate.

The Options Probability Code

Option market makers have to price their risk by gauging how much a stock could move in a give time period. The prices they are willing to pay for puts and calls "imply" the stock volatility they expect.

Right now, the implied volatility of October options which expire next week is fairly high at around 60%, while the next expiration is only at 40%. Options volatility is always expressed as annualized standard deviation, but we can use an options probability calculator to convert that annual number to one that tells us how much the stock could move right after the earnings report.

The options probability calculator above (click to enlarge) is from the broker OptionsHouse. Using the October 22 options expiration, it calculates the roughly 60% implied volatility to produce a 1-standard deviation price range of $489 to $602.

This means that with about a 68% probability, GOOG will be trading somewhere in this range by the end of next week. This may seem like an easy guess to make, but imagine if market makers were selling October 550 strike calls for only a 40% volatility. They would likely lose money if GOOG soared above $580, the upper band of 1-standard deviation for that vol.

I ran this calculation when the stock was trading around $545 on Tuesday. And I put target prices $60 higher and lower than that. Notice that 1-standard deviation falls within my $120-wide window.

The big question then is whether or not GOOG knocks the cover off the ball again. Many elements are in place for an upside stock surge of $40 or more, including attractive forward valuations, a nice bounce off of support at $480 last week, and expanded options volatility that has only come down slightly since that sell-off.

All it would take is another strong quarter of earnings and optimistic guidance. See you Thursday after the close for the GOOG fireworks show.

Kevin Cook is a Senior Stock Strategist with Zacks.com

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