Alphabet Stock (GOOG) (GOOGL): Illustrating Present Value With A Crayon

Stock Market

Googleplex - Google Headquarters with Android figure

Googleplex – Google Headquarters with Android figure

SpVVK/iStock Editorial via Getty Images

When contemplating an initial purchase of Alphabet, Inc. (NASDAQ:GOOG) (NASDAQ:GOOGL) for our value-oriented family portfolio, I thought of meaningful quotes from super investors Peter Lynch and Howard Marks.

In Beating the Street (New York: Simon & Schuster, 1994, p. 27), Lynch writes: “Never invest in any idea you can’t illustrate with a crayon.”

His apt quote resonates with my end-user experience of Alphabet based on years of using Search, Chrome, Drive, Gmail, Maps, YouTube, Analytics, Ads, and AdSense. Although unable to offer anything intelligent on Google’s algorithms and machine learning, I can attest to consumer-friendly online products that are highly productive tools.

In The Most Important Thing (New York: Columbia University Press, 2011, pp. 19-20), Marks postulates: “The choice isn’t really between value and growth but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on the analysis of a company’s current wealth.”

Lynch’s crayon metaphor and Marks’ growth vs. value juxtaposition debunked my previous reliance on deep-dive analysis, business modeling overkill, and foolish attempts to predict specific future outcomes when selecting individual stocks. My renewed approach led to a transition from an underperforming, near-sighted stock trader to a market-beating, far-sighted stock investor.

In my first report on Alphabet, I put the GOOGL voting shares through my data-driven investment research checklist of the value proposition, shareholder yields, returns on management, valuation multiples, and downside risk. The resulting investment thesis: Perennial growth stock of a fundamentally superior enterprise now available at a reasonable price for longer-term value investors.

Unless noted, all data presented is sourced from Seeking Alpha and YCharts as of the market close on February 18, 2022; and intended for illustration only.

A complimentary Glossary of Investing Terms is provided in a linked Google Sheet for article brevity and quick reference. The glossary is exclusive to Seeking Alpha readers. It is recommended to open the sheet in a separate window or tab. For convenience, a link back to SA is provided.

Win-Lose-Win Value Proposition

GOOGL is a non-dividend-paying large-cap stock in the communication services sector’s interactive media and services industry.

Alphabet Inc. provides online advertising services in the United States, Europe, the Middle East, Africa, the Asia-Pacific, Canada, and Latin America. The company offers performance and brand advertising services. It operates through Google Services, Google Cloud, and Other Bets segments. The Google Services segment provides products and services, such as ads, Android, Chrome, Google Maps, Google Play, Search, and YouTube; subscription-based products; and Fitbit wearable devices, Google Nest home products, Pixel phones, and other devices, as well as in-app purchases and digital content. The Google Cloud segment offers infrastructure, platform, and other services; Google Workspace that include cloud-based collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar and Meet; and other services for enterprise customers. The Other Bets segment sells health technology and internet services, as well as licensing and research and development services. The company was incorporated in 1998 and is headquartered in Mountain View, California.

(Source: Seeking Alpha)

Ultimately, investing in individual common stocks should aim to beat the benchmark index over time. For example, the charts below demonstrate how GOOGL has outperformed its broader sector, represented by the Communication Services Select Sector SPDR Fund ETF (NYSE:XLC) since XLC’s inception, and the overall market per the SPDR S&P 500 ETF Trust (NYSE:SPY) in the last ten years.

Nevertheless, most outperformance occurred during the Fed-fueled growth stock rocket ship.

My value proposition elevator pitch for Alphabet: Market dominant product line is a win-lose-win. Win an anti-trust case in court, or lose the case but pay minimally accretive fines, or win out-of-court by negotiating the spin-off of the affected brand at likely enormous capital gains and a retained stake.

Data by YCharts

Data by YCharts

Shareholder Friendly When It Needs To Be

As part of my due diligence, I average the total shareholder yields on earnings, free cash flow, and dividends to measure how the stock compares to the prevailing yield on the 10 Year Treasury benchmark note.

Earnings Yield

I target an earnings yield greater than 6 percent or the equivalent of a P/E multiple below 17 times.

With trailing one-year earnings per share of $112.23, the earnings yield for GOOGL was 4.30%.

Free Cash Flow Yield

I target a free cash flow yield or FCFY of 7 percent and higher or the equivalent of fewer than 15 times the inverted price-to-free cash flow multiple.

Based on $98.85 free cash flow per share, the FCFY for GOOGL was 3.79%.

Dividend Yield

Although not a dividend investor by definition, I prefer dividend-paying stocks for compensation in the short term while waiting for capital gains to compound over time. However, I am open to non-dividend paying stocks if the company executives and directors are competent capital allocators and potential dividend payers.

Of course, as a non-dividend stock, the trailing yield for GOOGL was 0.00%.

Average of Yields vs. the 10 Year Treasury

Next, I take the average of the three shareholder yields to measure how the stock compares to the prevailing yield on the 10 Year Treasury benchmark note. The average shareholder yield for GOOGL was 2.70% vs. 1.93% for the 10-Year.

Arguably, equities are deemed riskier than U.S. bonds. However, equities that reward shareholders at higher rates than the government benchmark, even razor-thin yields such as GOOGL, favor owning the stock instead of the bond.

Remember that earnings and free cash flow yields are inverses of valuation multiples, and each suggests GOOGL as overvalued. I’ll further explore valuation later in this report.

Although Alphabet’s yields do not scream shareholder-friendly, its infamous IPO auction, aggressive share buybacks, and pending 20:1 stock split suggest otherwise.

My weighted shareholder yields rating for GOOGL: Bullish.

Data by YCharts

High-Quality Enterprise

Now, let’s explore the fundamentals of Alphabet, uncovering the performance strength of its senior management.

Revenue Growth

When analyzing a business, I am biased toward established growth instead of executive promises and sell-side analyst projections.

Alphabet had a three-year CAGR revenue growth of 32.39%, far superior to the communication services sector’s 9.68% median growth.

Net Profit Margin

I screen for profitable companies to avoid unnecessary speculation, as witnessed in the money-losing disruptive growth stocks of late.

Alphabet had a trailing three-year steady pre-tax net profit margin of 29.51%, again, far superior to the 6.91% median net margin level for the sector.

Return on Equity

Return on equity or ROE reveals how much profit a company generates from shareholder investment in the stock. I target an ROE of 15 percent or higher to discover shareholder-friendly management.

Alphabet had an extraordinary trailing three-year return on equity of 32.05% against a 9.87% median ROE for the sector.

Return on Invested Capital

Return on invested capital or ROIC measures how well a company uses its working capital to generate returns.

I target an ROIC above 12 percent, and Alphabet had a 30.30% three-year trailing return. The performance indicates that senior executives are highly efficient capital allocators. On the contrary, returns market-wide appeared challenged during the pandemic.

The ROIC needs to exceed the weighted average cost of capital or WACC by a comfortable margin giving credence to management’s ability to outperform its capital costs. For example, GOOGL had a trailing weighted average cost of capital of 7.92% (Source: GuruFocus).

The ample spread between ROIC and WACC, combined with the aggressive topline growth, double-digit net profit margin, and outstanding returns on equity and capital, indicate a superior management performance in Mountain View.

My weighted returns on management rating for Alphabet: Bullish.

Data by YCharts

At A Reasonable Price For A Growth Stock

As highlighted in my latest book, Build Wealth With Common Stocks: Market-Beating Strategies for the Individual Investor, I rely on four valuation multiples to estimate the intrinsic value of a targeted quality enterprise’s stock price.

The book is a case study on our concentrated family portfolio of predominantly dividend-paying common stocks that have collectively outperformed the broader market since 2009 based on an equal-weighted average total return of each position vs. the S&P 500 during the same holding periods. Access to The Model Portfolio is, at present, complimentary. Visit my Seeking Alpha Author Profile for the link.

Please note that I do not attempt to predict specific future share prices or percentage targets as I view such practices as arbitrary, if unreliable.

Price to Sales

The price-to-sales ratio or P/S measures the stock price relative to revenues.

I target fewer than 2.0 times, and GOOGL had a price-to-sales ratio of 6.86. By comparison, the trailing median P/S was 1.65 for the communications services sector and 2.87 times sales for the S&P 500. Thus, sector and market sentiment suggest that GOOGL is overvalued relative to Alphabet’s topline.

Price to Earnings

Although often a hit or miss multiple, I target price-to-trailing earnings or P/E of fewer than 17 times or below the target stock’s industry averages.

GOOGL had a price-to-earnings multiple of 23.24, compared with the sector median P/E of 18.61, indicating that investor sentiment slightly overvalues the stock price relative to Alphabet’s earnings. Further, GOOGL appears fairly valued to the S&P 500’s recent overall P/E of 24.46 (Source of S&P 500 P/E: Barron’s)

Price to Cash Flow

I target single-digit price-to-operating cash flow multiples for the best value.

GOOGL had a price to cash flow of 19.28, compared to the sector median of 9.17, indicating the market places a premium on the stock price relative to Alphabet’s current cash flows.

Enterprise Value to Operating Earnings

Enterprise value to operating earnings or EV/EBIT measures whether a stock is overbought, a bearish or neutral signal, or oversold, a bullish or neutral signal, by the market.

I target an EV/EBIT of fewer than 15 times, and GOOGL was trading at 17.53, compared to a sector median of 16.89 times, signaling the stock was fairly valued to the sector but slightly overbought by the market.

Margin of Safety

Investing in the stock market is not rocket science. On the contrary, I have discovered that uncovering the common shares of quality companies temporarily trading at reasonable prices is basic science.

I am biased toward outstanding companies whose share prices are temporarily experiencing out-of-favor market sentiment as suggested by lower ratios of price-to-sales, price-to-earnings, price-to-operating cash flow, and enterprise value to operating earnings. Thus, I weigh the above key indicators to determine the overall market valuation of the targeted company.

The weighting of my four preferred valuation multiples suggests that the market has continued to place a premium on Alphabet’s stock price as of this writing. Therefore, based on the fundamentals and valuation metrics uncovered in this report, risks and catalysts notwithstanding, I would call GOOGL the fairly valued or perhaps overbought growth stock of a dominant operator in the interactive media and services industry.

Note GOOGL’s valuation multiples, except for P/S, have trended down since April 2021, an indication the growth stock may be moving in a value investor’s direction.

My weighted valuation rating for GOOGL: Neutral.

Data by YCharts

Paradoxical Low-Risk Growth Stock

When assessing the downside risks of a company and its common shares, I focus on five metrics that, in my experience as an individual investor and market observer, often predict the potential risk/reward of the investment.

I assign a downside risk-weighted rating of above average, average, below average, or low, biased toward below average and low-risk profiles.

Economic Moat

Alpha-rich investors target companies with clear competitive advantages from their products or services. An investor or analyst can streamline the value proposition of an enterprise with a moat assignment of wide, narrow, or none.

For example, Morningstar assigns Alphabet a wide moat rating.

We assign Alphabet a wide moat rating, thanks to sustainable competitive advantages derived from the company’s intangible assets, as well as the network effect. We believe Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and machine learning, as well as access to and accumulation of data that is deemed valuable to advertisers. We also believe that Google’s brand is a significant asset, as “Google it” has become eponymous with searching, and regardless of actual technological competency, the firm’s search engine is perceived as being the most advanced in the industry.

–Ali Mogharabi, Senior Equity Analyst, Apr 8, 2021.

Long Term Debt Coverage

A favorite of the legendary value investor Benjamin Graham, long-term debt coverage demonstrates balance sheet liquidity or a company’s capacity to pay down debt in a crisis. Generally, one-and-a-half times current assets to long-term debt is ideal.

As reported on its December 2021 financial statements, Alphabet’s long-term debt coverage was 14.65, or near 15 times the liquidity necessary to cover its longer-term leveraging needs. Moreover, in a further test of the company’s paydown capacity, its long-term debt to equity was 5.89%, well below my 200% ceiling. In other words, investors should become concerned only when a company’s debt is more than twice its equity.

I wonder if Alphabet carries a small but symbolic debt level to leverage low-interest rates or maintain pay-on-time credit ratings?

Short Term Debt Coverage

Current liabilities coverage or current ratio measures the short-term liquidity of the balance sheet.

I target higher than 1.00, and Alphabet’s short-term debt coverage was 2.93, providing near three times the liquid assets necessary to pay down its current liabilities such as accounts payable, accrued expenses, and income taxes.

Stock Price Volatility

As a long-term investor, I use a five-year beta trend line and screen for stocks with betas lower than 1.25 or no more than 125% volatility to the market.

GOOGL’s 60-month trailing beta was 1.08, and its 24-month beta was 0.92, reflecting a stock that offers price volatility about equal to the S&P 500 on the whole.

Short Interest

The short interest percentage of the GOOGL float was 0.38%, well under my 10% ceiling. Bears appear to view GOOGL as a core-level growth holding in institutional and retail portfolios.

Alphabet is a fundamentally superior company with a congruent risk profile.

My weighted downside risk rating for GOOGL: Low.

Buy A Slice of Alphabet’s Current Wealth

Catalysts accelerating or contradicting my overall bullish investment thesis on Alphabet and its stock include, but are not limited to:

  • The upcoming 20:1 stock split elevates the current 22% ownership of shares outstanding by retail investors, leading to a market sentiment-driven stock price increase.
  • On the contrary, institutional investors decrease ownership when retail investors charge in, although each is more often guilty of trading in and out of stocks based on geopolitical events, company or sector news, and earnings releases.
  • The more likely outcome is Alphabet continues to deliver productivity for its customers and alpha for its shareholders.

Drawing this report’s conclusion with a crayon: A reasonably-priced slice of Alphabet’s high-quality, low-risk, growth-oriented enterprise has a place in the portfolios of long-term buy-and-hold value investors.

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