Benefit From Google's Revenue Growth

| About: Alphabet Inc. (GOOG)

Summary

Alphabet stock is strongly outperforming the market.

The stock price appreciation is justified by the growth rate of the earnings and intrinsic value.

Alphabet is strongly positioned to continue this growth in the coming years.

Call options on GOOGL are cheaply priced due to the low implied volatility market environment.

Historical Performance

When we compare the long-term performance of Alphabet Inc. (GOOG, GOOGL) stock with the performance of the S&P 500 ETF (NYSEARCA:SPY), we can see Alphabet Inc. has strongly outperformed the market index.

Source: StockCharts.com

The outperformance started already in 2006, and the current stock price momentum is not slowing down its speed. The share price of GOOGL is currently at $834, bringing the total market capitalization value to $567 billion (the second-largest market cap, right after Apple Inc. (NASDAQ:AAPL)).

Personally, I have been following Alphabet's stock price performance closely in the previous years. I have bought a few shares in 2015, when the price was around the $550 level, but it always remained a small position in my stock portfolio. The reason why I did this was because I considered the stock price elevated from a technical point of view. The price has been growing strongly almost continuously in the previous years without much of a pullback. As a consequence, this company remained on the watchlist of stocks I would buy if the markets crashed (like in 2008-2009).

That's not to say I don't believe in the company fundamentally. I use Google daily (everyone I know does), and the companies I worked for are all advertising via the Google website. I strongly believe Google will keep growing its income flow from advertising and will keep increasing its market value. While Alphabet is more than just Google (the advertising business), the strong income from this segment is, for me, the most important reason buy this stock and hold it in my portfolio for many years.

In the beginning of 2017, I forced myself to take a closer look into the fundamentals of Alphabet, its earnings growth and what can likely be expected in the future from this company and its stock price. I will present a short summary of these results in this article and demonstrate a trade idea to benefit from Google and its future price performance.

Fundamentals of Alphabet

The revenue of Alphabet is currently $90 billion for 2016 (up from $0.4 billion in 2002). Growth in revenues has been realized year after year:

(Source: Statista)

The bulk of this revenue comes from the advertising business of Alphabet Inc. A question worth asking here is: Will the growth of the advertising business in general continue as well in the coming years?

A recent report from the Internet Advertising Bureau details the quarterly growth in the advertising income since 1996. As can be seen from this chart, income from advertising is still growing strongly. Internet ad revenues increased by 20% in Q3 2016 (year over year).

(Source: Interactive Advertising Bureau)

Being the most dominant player in the online search market, Google has seen its income increase steadily. We should also keep in mind the other business fields Alphabet is active in, outside of advertising. The company calls this segment "Other Bets". While income from this segment is small in comparison to that from the advertising segment, it could become more significant in the future. Shareholders of Alphabet will benefit from successes in this segment as well once the income starts to increase.

In the table below, Alphabet's fundamentals for the previous years are summarized. I expect these growth rates to continue in the coming years, just as they have been doing since the inception. The stock price of Alphabet is bound to appreciate further with these underlying fundamentals.

(Source: YCharts)

Opportunity: Buy long-term call option on Alphabet

Considering these points above, we think Alphabet remains a strong investment in 2017 and in the upcoming years. The current P/E ratio of the stock price is 30, which seems reasonable given its current position.

For this reason, we would suggest initiating a long position in a call option contract on Alphabet. In this way, you can minimize your required investment to benefit from a rise in the underlying stock price. Here we would suggest buying a call option contract expiring on January 19, 2018, with a strike price of $900 (around 8% above the current stock price).

(Source: Nasdaq.com)

This call option contract gives the holder the right to buy 100 shares of Alphabet for $900 at any time until 19/01/2018. The total cost of the call option contract will be $4,169 ($41.69 per common share).

The trade has the following benefits:

  • The implied volatility of Alphabet is currently low (13%), considering the implied volatility levels it faced in the past. This implied volatility is the main driver of option prices on Alphabet, which means the options are inexpensive at these IV levels. This low volatility can also be seen in the general stock indices, which are currently making new highs.

(Source: Optionistics)

  • The profit potential is highly leveraged compared to a simple purchase of Alphabet common stocks. In the graph below, we compare the profit profile of the call options with the profit profile of common GOOGL stocks:

(Source: Yahoo Finance)

  • The expiration of the call options is on 19th January, 2018, giving the stock price of Alphabet time to increase in value.
  • The risk of this option investment is limited to the debit amount paid for the call options. A purchase of 100 GOOGL stocks would currently cost $83,400. This call option contract only costs $4,169 and will also give you upward potential from appreciation in the stock price of GOOGL.

The main disadvantage of this call option investment (compared to an investment in the common stock) is the timing. If the common stock declines in the upcoming months, the premium of the GOOGL calls will decline strongly as well. With GOOGL stocks, you can just hold on to your stock and wait for better times, while you don't have this luxury with the call options.

In conclusion

GOOGL has seen its stock price rise strongly in the previous years, systematically beating the S&P 500 stock index. This can be explained by the company's strong fundamentals and its growing revenue from the advertising market. We expect this outperformance to continue in the future with a rising GOOGL stock price.

Investors who believe in GOOGL can buy common stock at $834 or purchase call options. We prefer the latter alternative, mainly because the implied volatility is this low. Call options are not expensive at these anticipated volatility levels, and investors can use this fact to make an investment in Alphabet Inc.

Disclosure: I am/we are long GOOGL.

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.

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