Google: Why Investors Need Not Fret

| About: Alphabet, Inc. (GOOG)
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Google (NASDAQ:GOOG) has seen a lot of heat coming its way after the earnings report as it has plummeted ~11% since last month. With the net profit of $2.18 billion down 20% YoY and Non-GAAP earnings per share recorded at $9.03 compared to $9.72 YoY, even the most unquestioning long term investors have been in a tizzy. Here are my reasons as to why investors need not worry and can go long on this monster of a stock.

The Growth Story - A Strength Analysis

While one should surely focus on the bottom line misses, I believe that the top line provided by Google is one of a kind in the market. The Company is an incredible growth story as it reported an increase in revenues by 45% YoY. One needs to understand the focus of Google- Google is all about its advertising business; every other thing it does is a by-product of that. While the net income was low this quarter, it was mainly because of the added baggage of Motorola Mobility due to which Google had to increase spending in R&D and SG&A by ~$1.16 billion, and not due to a decrease in search, which saw a nice 18% YoY increase in revenues. Let's look at Google's scope in search business:

1) Android, a step by Google to serve its ads seamlessly across the mobile platform, is revving up nicely. With Android representing 75% of all mobile shipments shipped last quarter, I would say that Google's bet in Android could generate much higher revenues in the future.

2) Another Fact people tend to forget about Google is its ownership in YouTube, which is another area where Google can monetize through ads.

3) With the U.S. market for internet search still going gung-ho as the search business grew by 11 per cent since last December, I believe that Google fever is here to stay.

A Conservative Discounted Cash Flow valuation gives heavy safety margins

Let's take a look at Google's DCF Valuation to calculate the intrinsic value of the company and hence determine the fair value for the stock. As Google has a considerable economic moat, has a historical trend of positive cash flows and has pretty much less competition, it is a good fit for the DCF model. To define the values of our modelling inputs, we take the following assumptions:

FCF Growth Rate: As Google has actually increased the FCF by around 400% in the past 4 years, a 20% growth rate seems reasonable.

Discount Rate: I will use a 12% discount rate to take into factor the time value of money.

Decay rate: The growth cannot remain the same for every year. Let's assume that the FCF growth will decay at a rate of 8% considering the low competition that Google faces at this point of time.

We get the discounted value of the company as 153 billion.

Perpetuity rate: We are assuming that we can forecast about the company for a maximum of 10 years, past which we assume that Google will continue to grow at a modest 3% rate, which is the rate at which US economy grows. It renders the perpetuity value at $541 billion, which, discounted to the present, comes out to be $174 billion.

With Google's Free Cash Flow of $12,670 million in the last twelve months and cash holding of $16,260 million, Google's intrinsic value by this valuation comes out to be ~ $343 billion (DCF Value+ Perpetuity Value + Cash in hand) which renders the fair value of shares at $1,050 per share and gives a heavy 37% margin of safety.

The Competition

As I have previously mentioned that advertising is Google's moat, let's take a look at the players in the advertising business to see the dangers to Google. As of now, Google has the largest market share in search and mobile advertising. According to a recent study the company will overtake Facebook (NASDAQ:FB) in the online display ads business in 2012 with 15.4% of the total display market compared to 14.4% for Facebook. I believe that it was to be expected considering that Google provides much higher value than Facebook with its advertising is based on search parameters and hence is more targeted. Google's two biggest competitors in the search sector, Microsoft (NASDAQ:MSFT) and Yahoo (YHOO) currently stand at 15.9% and 12.2% respectively in US internet share. With things going south for both Microsoft and Yahoo in the search market, I believe that Google will continue a hold on its leading market position in the advertising business.

The Bottom Line

With the strong secular growth in online advertising and its clear leadership in the search business, Google can more than justify its current stock price. In fact, after performing a DCF analysis on Google, we realize that Google is significantly undervalued at the current levels, with a 37% margin of safety. I believe that the recent sell-off after earnings provides investors with a clear window of opportunity, and hence I would rate Google as a buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.