Where Is Alphabet's Stock Headed?

Alphabet Inc. (NASDAQ:GOOGL) (NASDAQ:GOOG) has recently been in the news for its founders Larry Page and Sergey Brin stepping down and handing over the reins to Google CEO Sundar Pichai. The company's stock price experienced no hiccups whatsoever on this announcement as it continued its smooth upward run.

When one analyzes the stock in retrospect, one fact that comes to light is that very few long-term investors would have actually lost money on a company like Alphabet. With a robust business model and a wide array of business units including cash cows like Google Search, YouTube and Android, the stock has always been an outperformer and will likely continue to be a relevant investment for the coming decade.


A must-have in any investor's portfolio

When one analyzes the fundamentals of Alphabet, it is hard to find a reason why this stock shouldn't be in any long-term portfolio. The company has a net margin of 21.04% resulting in a return on equity of 17.76%, and its average annualized revenue growth for the past three years has been as high as 21.6%. The debt levels are also very low, with a Debt-to-Ebitda ratio of 0.28.

As per the above chart, it is evident that Alphabet's share price has grown by as much as 70% in the past three years. Despite the strong fundamentals and phenomenal growth, the valuation multiples are not as high as one would imagine. The stock is trading at an enterprise value-revenue multiple of 5.24 and a price-earnings ratio of 28.75, which is lower than many tech companies with business models that are not half as promising as Alphabet's.

Google Search is the ultimate star

When analyzing the different business units of Alphabet, the first one to look at is its core search engine business. As the value of global marketing spends is going up, the amounts spent by corporations on digital marketing are also going through the roof. One of the primary forms of digital marketing is SEM (Search Engine Marketing) and it happens to be one of the largest revenue streams generated through Google Search. Every startup across the globe that has successful fundraising tends to have a separate budget just for Google's search engine marketing.

This is because the two most visited websites across the globe are Google and Youtube. There is some competition from Facebook (NASDAQ:FB) and Amazon (NASDAQ:AMZN) in the digital marketing space, but nothing too threatening. This line of business is a real star for Alphabet as it is contributing heavy amounts of cash to the bottom-line and is expected to grow at a double-digit rate over the coming five years.

YouTube has shown strong resilience to competitive threats

Once streaming services like Netflix (NASDAQ:NFLX) and Amazon Prime starting seeing a sharp rise in their subscriber base, it was logical for investors to wonder how badly YouTube would be affected. The same was the case when Instagram, which has gained a startling amount of mileage as a photo and video sharing platform, launched its video feature to compete with YouTube. Despite all these competitive threats, YouTube continues to be the second-most visited site in the world with a very high average duration per visitor, providing Alphabet with the ability to showcase more advertisements and generate greater revenue. It operates in a clear niche, and the impact of paid streaming services has fallen more on the television networks than on YouTube.

Android, Chrome and other initiatives

Android continues to be the most used operating system across mobile phones today, beating Apple's (NASDAQ:AAPL) iOS by a significant margin largely due to its openness and flexibility. Alphabet earns solid revenues from licensing this system to various mobile phone manufacturers across the globe. Similarly, Chrome continues to be one of the most popular browsers, which is contributing wonderfully to Alphabet's big data game. Since the company generates huge amounts of cash through these businesses where it has a dominant position, it can afford to spend heavily on innovations. Some examples of the new initiatives of Alphabet which might change the future of their industry are Waymo, a self-driving car venture, and Verily, a technology-based preventive wellness initiative.

Where is Alphabet headed - a discounted cash flow valuation

Particulars (USD Million)

2018

2019E

2020E

Revenues

136819.0

162666.9

191493.3

% growth

23.4%

18.9%

17.7%

Net Income

30736.0

32307.2

37643.6

% of revenues

22.5%

19.9%

19.7%

Free Cash Flow

19467.0

24400.0

28724.0

% of revenues

14.2%

15.0%

15.0%



For the purpose of valuing Alphabet and determining the expected value of the share in 2020, a discounted cash flow approach was used. All the numbers appearing under the 2020 column are assumptions, starting off with a 17.7% top-line growth assumption, which is lower than the company's growth in the earlier years. The revenue to free cash flow conversion is expected to continue to be around 15%. The 2019 numbers are also assumptions based on the current quarterly results of Alphabet.

Equity Risk Premium (S&P Global)

5.4%

Risk-Free Rate (10Y US Govt. Bond Rate)

1.7%

Levered Beta (Based on prevailing stock beta and Debt-Equity ratio)

1.03

Cost of Equity (Discount Rate)

7.3%



For the purpose of determining the discount rate, I used the Capital Asset Pricing Model, where the equity risk premium is determined at 5.4% using the S&P Global market rate and the risk-free rate is assumed as 1.7%, which is Alphabet's levered beta taken at 1.03. This leads to an equity discount rate of 7.3%.

Particulars

2018

2019E

2020E

Projected Market Capitalization (USD billion)

720.3

934.7

1046.9

Stock Price (USD)

1035.6

1343.0

1504.1

Price-to-Earnings

23.70

29.06

27.81

Price-to-Sales

5.26

5.75

5.47

Price-to-Free-Cash-Flow

37.00

38.31

36.45



The expected price of Alphabet in 2020 would be $1504.1, assuming that the company has a valuation of 5.47 times its revenue. Needless to say, this expected value of the stock has taken into account a number of assumptions that may or may not hold true. There are many factors affecting the stock price of Alphabet, and there is every possibility that this predicted value may not come to be.

Key takeaways

Alphabet has a strong tailwind in the near future in the form of the increasing amount spent by companies all over the world on SEM and user analytics data, for which Alphabet is the ultimate source. The company is also enjoying a leading position in the mobile operating systems market and the web browsers market. The management is constantly trying to reinvent themselves and introducing new models; a classic example of this was the Fitbit (NYSE:FIT) acquisition to go in sync with its Verily initiative. Alphabet has a lot left in it in terms of providing value to shareholders, and investors should hold tight to this stock in the coming years.

Disclosure: No positions.

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This article first appeared on GuruFocus.