Information provided is for educational and entertainment purposes only and in no way is to be considered financial advice. Before acting, you should consider seeking independent personal financial advice that is tailored to your needs
At Value Investor Academy we follow Warren Buffett’s 4 rules for investing in stocks.
The company must be:
- One that we understand
- With favorable long term prospects
- Operated by honest and competent people
- And available at an attractive price
Let’s see how Alphabet stacks up.
One that we understand
To understand a company we need to know who they are, what they do and how they make their money.
Who are they?
Alphabet is a collection of businesses the largest of which is Google.
It is a global company with International revenues accounting for approximately 54% of its consolidated revenues in 2021.
What do they do?
Alphabet has 3 business segments,
- Google Services
- Google Cloud
- non-Google businesses, known as ‘Other Bets’.
Google Services’ core products and platforms include ads, Android, Chrome, Gmail, Google Maps, Google Play, Search, and YouTube,
Google services hardware products include Pixel phones, Fitbit, Chromecast, Google TV, Google Nest Cams and Nest Doorbell.
Google Cloud is made up of the Google Cloud Platform and Google Workspace.
Google Cloud Platform enables developers to build, test, and deploy applications on its highly scalable and reliable infrastructure.
Google Workspace includes collaboration tools such as Gmail, Docs, Drive, Calendar and Meet.
Other Bets is Alphabet’s venture capital and private equity division. It invests in emerging businesses at various stages of development, ranging from those in the R&D phase to those that are in the beginning stages of commercialization. Examples include Slack, DocuSign, Impossible Foods and Uber.
How do they make money?
- Advertising. They generated more than 80% of total revenues from the display of ads online in 2021.
- Google Play generates revenues from sales of apps and in-app purchases and digital content sold in the Google Play store.
- Hardware generates revenues from sales of Fitbit wearable devices, Google Nest home products, Pixel phones, and other devices.
- YouTube non-advertising generates revenues from YouTube Premium and YouTube TV subscriptions and other services.
- Google Cloud Platform generates revenues from infrastructure, platform and other services.
- Google Workspace generates revenues from cloud-based collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar and Meet.
Favorable long term prospects
In order to determine if a company has favorable long term prospects, we need to analyse its financial history, determine if they have any competitive advantages or “moats”, evaluate the industry, and determine any headwinds the company may be facing.
Alphabet has consistently grown revenue, net income, free cash flow and book value over the past 10 years. Its operating margins have remained consistent within the 20 to 30% range. Return on invested capital (ROIC) is generally around 15%. Debt to equity has increased over time but remains well below the rule of thumb of less than 100% and interest repayments are covered hundreds of times by earnings.
The word ‘Google’ has become synonymous with the word ‘search’.
When I think email I think Gmail
If I want to watch a video I go to Youtube.
Google has built strong brands used every day by billions of people.
Alphabet makes most of its money through advertising. Advertisers pay money to get their ads in front of users. Google has the largest user base out of any of the online advertisers. This makes Alphabet the most attractive medium to display ads.
Google has between 85% and 93% of the total search engine market share.
Advertisers want to make sure their ads are getting in front of the right people. To make sure this happens Google needs to collect data from its users. According to semrush.com Google has 4.3 billion users worldwide. With such a huge amount of users Google is able to build the best algorithm to ensure the right ads are being displayed to the right people.
Online advertising is a growing industry with ad expenditure in the US expected to surpass $300 billion by 2025.
In 2021 Google accounted for over 28% of all digital ad spending in America.
Alphabet faces heightened scrutiny from both U.S. and foreign governments with respect to their compliance with laws and regulations. Many of these laws and regulations are evolving and their applicability and scope, as interpreted by the courts, remain uncertain.
the U.S. Department of Justice, joined by a number of state Attorneys General, filed an antitrust complaint against Google on October 20, 2020, alleging that Google violated U.S. antitrust laws relating to Search and Search advertising.
Cyclical nature of advertising
Expenditures by advertisers tend to be cyclical reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions have affected, and may in the future affect, the demand for advertising,
Alphabet lists the following areas of competition and the competitors within those areas:
- General purpose search engines and information services, such as Baidu, Microsoft’s Bing, Naver, Seznam, Yahoo, and Yandex.
- Vertical search engines and e-commerce providers, such as Amazon and eBay (e-commerce), Booking’s Kayak (travel queries), Microsoft’s LinkedIn (job queries), and WebMD (health queries).
- Social networks offered by ByteDance, Meta, Snap, and Twitter.
- Other online advertising platforms and networks, such as Amazon, AppNexus, Criteo, and Meta.
- Other forms of advertising, such as billboards, magazines, newspapers, radio, and television.
- Companies that design, manufacture, and market consumer hardware products, including businesses that have developed proprietary platforms, such as Amazon, Apple, and Microsoft.
- Digital assistant providers, such as Amazon and Apple.
- Providers of enterprise cloud services, such as Alibaba, Amazon, Microsoft, and Salesforce
- Providers of digital video services, such as Amazon, Apple, AT&T, ByteDance, Disney, Hulu, Meta, and Netflix.
- Other digital content and application platform providers, such as Amazon and Apple.
- Providers of workspace connectivity and productivity products, such as Meta, Microsoft, Salesforce, and Zoom
Viability of “Other Bets”
Investing in new businesses, products, services, and technologies ultimately may not be commercially viable or may not result in an adequate return of capital. In pursuing new strategies, Alphabet may incur unanticipated liabilities. These alternative ventures may also divert resources and management attention from current operations.
Operated by honest and competent people
Alphabet is run by Sundar Pichai, who has served as CEO of Google since 2015 and as CEO of Alphabet since 2019. Sundar has a degree in metallurgy from the Indian Institute of Technology Kharagpur and a Masters in engineering and materials science from Stanford University.
Sundar briefly worked at the management consulting firm McKinsey & Co but soon joined Google in 2004 as the head of product management and development. In 2008 he was named vice president of product development. In 2012 he became senior vice president and by 2014 was made product chief over both Google and the Android smartphone operating system. In 2015 Sundar was named CEO of Google and in 2019 CEO of Alphabet.
From 2015 to 2021 Alphabet has grown revenue from just under $75 billion to over $257 billion and market cap from around $570 billion to just under $2 trillion netting investors a compounded annual return of approximately 27% per year over that time.
Available at an attractive price
A stock is available at an attractive price when you believe its price is less than its intrinsic value. Determining intrinsic value is difficult. Two ways to determine intrinsic value is through comparative analysis and absolute analysis (such as a discounted cash flow).
Comparing P/E to history
Since 2009, Alphabet typically trades within a P/E range of 20 to 30. Its P/E is currently 19.7 indicating it is at the bottom of its typical range.
P/E to industry and market
Compared to the US Interactive Media and Services Industry Median Alphabet is cheap based on P/E. It is expensive compared to the entire market, however.
Discounted Cash Flow Analysis
When conducting a discounted cash flow you essentially predict the future cash flows of a business, then discount those cash flows back to their present-day value.
Because discounted cash flows are trying to predict the future there is a high chance that they are wrong. Because of this, it may be a good idea to conduct several discounted cash flows using varying growth rates.
For example, we can calculate the possible value of Alphabet using 3 different scenarios.
The first assumes Alphabet will grow free cash flow at 20% for the next 5 years and then at 15% for 5 years after that, it then assumes free cash flow will grow at a rate of 2.5% into perpetuity. If we discount those cash flows by 10% back to their value at present-day we get a value of $4,127.
The second scenario assumes free cash flow grows by 15% for the next 5 years and by 10% for the 5 years after that. It assumed a 2.5% growth rate into perpetuity and 10% discount rate. This determined a value of $2869
The third scenario grows free cash flow by 10% for 5 years, then by 5% for 5 years after that. It assumed a 2.5% growth rate into perpetuity and a 10% discount rate. This determined a value of $1995.
Using different growth rates we get 3 different potential values for Alphabet.
Which is right?
No one honestly knows. These are just 3 of the infinite possible outcomes for Alphabet. As an analyst, it is up to you to determine an appropriate growth rate and figure out your own value.
Here are some valuations from other sources.
How I determined growth rates.
In scenario 1 I looked at the historical 10-year CAGR of free cash flow. This was 19.6%. I then looked at the estimate provided by Zacks. According to them, analysts expect Alphabet to grow at 19.01% over the next 3 to 5 years. For simplicity, I used a growth rate of 20% for the first 5 years. I then assumed growth declined by 1% per year for the next 5 years to get a growth rate of 15% for the following 5 years.
For scenario 2 I used a growth rate of 15% for the first five years as this is approximately the rate at which book value has grown for the past 10 years. Why did I use book value? Warren Buffett says “the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value”. I then reduced the growth rate by 5% over the next 5 years.
For scenario 3 I used a growth rate of 10% to get a low-value estimate. 10% is approximately half the rate Alphabet has grown over the past 10 years. I then reduced the growth rate by 5% over the next 5 years.
Probability of Scenarios
Next, I assigned probabilities to the 3 scenarios.
I assumed scenario 2 had a 50% likelihood of occurring and scenarios 1 and 2 both had a 25% chance.
I then calculated a weighted average price of $2,965 based on these probabilities. At the current price of $2,277, this indicates a potential 23.2% discount.
Is Alphabet a Good Investment?
Alphabet’s last traded price was $2,277, so is it available at a good investment? Only you can determine that.
Do you understand the company?
Do you think it has favorable long term prospects?
Do you believe the company has honest and competent management?
Do you think it is available at an attractive price?
Let us know what you think by leaving a comment below.
Here are some recent opinion pieces on Alphabet
Alphabet (GOOGL) – by Value Stock Geek – Security Analysis (substack.com)
Is Alphabet’s Stock a Buy Now? | The Motley Fool
Why Alphabet (Google) Stock Is Still A Buy (NASDAQ:GOOG) | Seeking Alpha
Disclosure: Employees of Value Investor Academy hold shares in Alphabet.
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