Alphabet: New Name, Same Strong Performance

| About: Alphabet Inc. (GOOG)
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Alphabet continues to grow revenue at a healthy pace. The firm is pleased with the momentum it is seeing from its mobile division, particularly within mobile advertising.

The company has sold Motorola Mobility, a value-creating move as it can now allocate more capital to high-return opportunities. Maybe aggressive buy backs?

Alphabet is a holding in the portfolio of the Best Ideas Newsletter. We like its valuation, growth potential, cash-flow generation and competitive profile.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Alphabet's Investment Considerations

Investment Highlights

• Known for its search dominance that it maintains, Alphabet (NASDAQ:GOOG) is a tech company focused on a number of things: social, Android, ads, YouTube, Chrome, and research. We think the company will have some megahits in the years ahead, and we now value shares over $800 each. In 2015, the company lost ~$3.6 billion in 'Other Bets,' suggesting levels of profitability are much higher than reported.

• Google is a holding in the portfolio of the Best Ideas Newsletter. We like its valuation, growth potential, cash-flow generation and competitive profile. Very few firms are more attractive on a fundamental basis, in our view, and its future remains bright.

• Google continues to grow revenue at a healthy pace. The firm is pleased with the momentum it is seeing from its mobile division, particularly within mobile advertising. The mobile Internet space will be key for the company moving forward, but Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR) are not backing down. YouTube and programmatic advertising offer additional upside potential.

• Google has a strong future in search, and we continue to be in awe of the strength in this division. The company recently sold Motorola Mobility, a value-creating move as it can now allocate more capital to high-return opportunities or new concepts such as self-driving cars, Glass, Fiber, or other innovative ideas.

• Google has three different stock classes with two different tickers. GOOGL is Class A stock, and GOOG represents the non-voting Class C stock that was created by a stock split in 2014 in order for Google founders to maintain majority control.

• In the fourth-quarter of 2015, Alphabet reported accelerated revenue growth of 24% on a constant-currency basis, compared to the 18% mark in last year's period. GAAP and non-GAAP net income performed well, and the search giant recorded $8.67 per diluted share in earnings, beating the consensus number by nearly $0.60.

• Alphabet cut back on capital spending in the fourth quarter ($2.1 billion versus $3.6 billion), helping the company generate an impressive $4.3 billion in free cash flow, which bested the $2.8 billion level in the prior-year period. The company ended 2015 with $67.8 billion in net cash on its balance sheet.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Alphabet's 3-year historical return on invested capital (without goodwill) is 77.7%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.

Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.

Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co

In the chart below, we show the probable path of ROIC for Alphabet in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Alphabet's free cash flow margin has averaged about 22% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Alphabet, cash flow from operations increased about 85% from levels registered two years ago, while capital expenditures expanded about 35% over the same time period.

In fiscal 2015, Alphabet reported cash flow from operations of ~$26 billion and capital expenditures of ~$10 billion, resulting in free cash flow of ~$16 billion, representing a 41% increase from fiscal 2014.

Valuation Analysis

This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

Our discounted cash flow model indicates that Alphabet's shares are worth between $683-$1025 each. Shares are currently trading at ~$732, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $854 per share represents a price-to-earnings (P/E) ratio of about 35.9 times last year's earnings and an implied EV/EBITDA multiple of about 21.2 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 13.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 14.3%. Our model reflects a 5-year projected average operating margin of 32.2%, which is above Alphabet's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 5.6% for the next 15 years and 3% in perpetuity. For Alphabet, we use a 10.7% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $854 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

In the graph above, we show this probable range of fair values for Alphabet. We think the firm is attractive below $683 per share (the green line), but quite expensive above $1025 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Alphabet's fair value at this point in time to be about $854 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Alphabet's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $1162 per share in Year 3 represents our existing fair value per share of $854 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

With Google's transformation into Alphabet comes a new mission: to have its hand in everything from A to Z--hence the new name Alphabet. Though we are still getting used to the new name, we are loving its recent performance. Alphabet's fourth quarter was an impressive one, as it accelerated revenue growth and continued to build its fortress-like balance sheet. The firm's tremendous net cash position will play a vital role as it continues to expand its operations into a diverse tech company. The company now has six products or websites in its network that have over 1 billion users worldwide, simply an incredible reach. As a result of Google's stock split in 2014, we include both share classes (non-voting Class C, GOOG, and Class A, GOOGL) in the Best Ideas Newsletter portfolio, collectively one of its largest holdings (5%+). Alphabet currently registers a 7 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we 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.

Additional disclosure: Some of the firms mentioned in this article are included in the newsletter portfolios.