Over the past year or so it'd be fair to suggest that shares of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) have been reasonably volatile. Investor bids started 2015 in the low-$500 range and increased to the high-$700's by the end of the year; now the mark is closer to $700.
The fast growing nature of the business has lent itself to drastic changes in the share price. Seeing bids of $760 one day and $700 the next, or vice versa can be a bit off-putting when you're trying to figure a company out. Which brings up a natural question for the long-term investor: "How much should you pay for Alphabet?" Naturally the future is unknown, but it can nonetheless be instructive to think about the process.
To illustrate this concept, I'd like to focus on two methods: figuring out what the current share price might imply and then trying to "back out" a reasonable valuation. Let's start with the first method.
What could the current share price imply?
Recently Alphabet indicated that it had earned roughly $24 per share. Based on a share price around $700, this equates to a trailing earnings multiple around 29. We're working with round numbers - the idea isn't to get it down to the penny, instead it's about taking a high level view.
For a slower growing company like AT&T (NYSE:T) or Consolidated Edison (NYSE:ED), surely that sort of multiple would be too high. For a company like Alphabet, with much faster growth prospects, it could be warranted.
The growth estimates for the company have been pretty consistent among various sources - usually in the 16% to 17% range. If I were using a single growth estimate, I'd likely want to remain prudent and think about something in the 10% to 15% range as a maximum; better to be pleasantly surprised instead of needing excellent growth for things to turn out ok. As it stands, we'll use a wide set of assumptions, say 5% to 20% growth over the next decade.
Next you need to have an opinion on the future earnings multiple. Naturally this too is unknown, but we do have a bit of history. Over the past decade the average earnings multiple has been around 30, with the last five years averaging in the lower 20's. Now it's certainly possible that shares will trade with a higher multiple in the future, but I'd contend that this becomes less likely as the growth rate slows. Let's use future multiples in the 15 to 30 range. Here's what that could look like over a 10-year period:
As you can see the future share price can vary widely depending on your expectations. If you suspect that Alphabet can grow by 20% annually it's clear to see that today's price would be quite the deal. Of course it's important to keep in mind that this would simultaneously indicate that the company could be generating something close to $100 billion per year in profits.
Here's what that information looks like on an annualized return basis:
Once more if you suspect that Alphabet can keep up its 15% or 20% growth rate for the next decade, it's easy to see today's valuation could be reasonable. Alternatively, if you anticipate much slower growth the current valuation leaves some caution out there. (5% growth and a 15 multiple are good scenarios for some securities, for the Alphabet shareholder it could mean a decade of stagnation.)
What's interesting about this process is that it gives you a better feel for what an appropriate valuation might be. Intuitively we know that faster growing companies ought to command higher current (or trailing) valuations, but it's not always easy to quantify by how much.
The current mark near 29 seems a bit high in comparison to your typical firm, but the faster growth rate would allow for future P/E compression to potentially come in more "softly." If you believed that Alphabet would only grow by 10% and ought to trade at 20 times earnings, for instance, this still equates to a 6% annualized gain. The faster growth can make up for a higher valuation.
Here's a secondary way to look at it:
What "current" valuation is needed to achieve a 10% annual gain?
Instead of looking at how future possibilities compared to the current share price, it can be instructive to see what valuation multiple would be needed to reach a certain annualized gain. In this case we'll use 10%, but you can choose whatever base line you would like.
The "current" P/E in the table above indicates what starting earnings multiple would equate to a 10% annualized gain, should the first two assumptions come to fruition. So if you suspect that Alphabet can grow by 15% or 20% and ought to trade with a 20+ multiple, its clear to see that today's valuation is more than reasonable. Should this type of growth occur, you could have a P/E in the 30's or 40's and still see your investment work out well.
Of course, just because a company has lofty growth expectations this does not mean that it must play out this way. The future is always unknown. Two recent examples - Apple (NASDAQ:AAPL) and Chipotle (NYSE:CMG) - make this point well. Even exceptional growth stories have hiccups and slow-downs along the way. Furthermore, even if Alphabet were able to grow by say 16% annually for the next five years as anticipated, there's nothing stopping the 10-year growth from sliding lower.
Should the company "only" grow by 5% or 10% in the coming decade, today's multiple could be too high. The business could perform quite well, but P/E compression might result in investment performance that significantly trails the business results.
The "breakeven" with regard to investors seeing 10% annual gains appears to be along the lines of 10% to 15% future EPS growth and a 20 to 30 ending multiple. Obviously that's a wide range, but it gives you a feel for the process nonetheless. If you believe the company will grow faster than that or trade with a higher multiple, shares ought to look interesting. Alternatively, if you suspect the company can "only" grow by 8% or should trade under 20 times earnings then today's valuation appears less attractive.
In short, it's not enough to look at a trailing earnings multiple and decide whether a security looks "cheap" or "expensive." There are additional factors at play. More astute questions relate to what the current share price implies or else what a "reasonable" valuation might look like. These insights are based on your expectations, as all future decisions are, but the logical groundwork is a bit sturdier. So, how much would you pay for Alphabet?
Disclosure: I am/we are long T.
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.