Last month, I posed a serious question:
Just days later, we got our first hint Buffett himself was buying Apple (NASDAQ:AAPL)! Followed shortly after by that bombshell CNBC interview (here's the transcript), where he revealed an $18 billion plus Apple investment*, the vast majority bought by him in January and recent months (and the rest by Todd and Ted in early-2016). What better confirmation of my assertion that value investors - even the greatest of them all, at 86 years of age - would be wise to pose such a question to themselves?
[*Pretty sure Apple is Buffett's largest common stock investment ever (on a cost basis). In fact, I wonder if it's the largest stock investment ever made by a single investor (again, in terms of cost)? Sure, Todd, Ted, and Charlie did provide some inspiration and feedback here, but we can be sure Buffett never buys anything until he makes his own mind up! Thoughts?]
Granted, I got lucky.
Was I confident I'd see Buffett talking up an Apple position just weeks later? Um, no. [Don't forget, Icahn announcing a multi-billion holding some years back was a huge surprise too.] And maybe I chose it specifically as the largest, most obvious and controversial value stock out there. Not to mention, the head fake I pulled: While I did summarize its attractive fundamentals and valuation, my post clearly wasn't intended to be a detailed thesis. But hey, it was still the right question at the right time, so I'll take the kudos! And Buffett's purchase now serves as great inspiration to present a genuinely compelling investment thesis here. Just not Apple - I mean, who even needs a thesis right now when Buffett has put so much money where his mouth is? Instead, we'll focus on a company which is arguably the antithesis of Apple - therefore, I ask:
So Why Not Google It?
Yeah, it's Alphabet Inc. (NASDAQ:GOOGL) (NASDAQ:GOOG). While the new holding company moniker isn't so recognizable, almost everybody on the planet interacts with its products on a daily basis - Search, Android, Maps, Chrome, YouTube, Google Play and Gmail each have over 1 billion monthly active users! Obviously, no introduction is needed here, but if you haven't read them recently, I recommend two key documents: 'An Owner's Manual' for Google Shareholders, from the 2004 IPO (inspired by Buffett), plus the Alphabet Letter, which details the 2015 transition to a holding company for Google and Other Bets (again, inspired by Buffett). Note particularly the core 'mission statement':
'Google is not a conventional company. We do not intend to become one.'
But while we may love Google's story and products, many haven't considered it any more seriously as an investment than Apple. You know why - in no particular order: It's a technology company, it's a technology company that's totally dependent on advertising revenues, its costs-per-click keep falling, many of its products and services have completely bombed, its talent could and probably will walk out the door tomorrow, it's throwing money away on moonshots, it could be superseded by a better mouse-trap tomorrow, its CFO is an over-compensated innovation killer, it's sitting on mountains of idle cash, its dual-share structure is evil, it belongs in the too-difficult pile, it's a black box, who knows, etc.
In reality, that list tells you as much about the biases of investors themselves - such objections aren't necessarily correct, or even grounded in facts and figures. Which we'd do well to focus on - here's the last decade of Alphabet/Google results, complete with 5 and 10 year CAGRs:
Focusing on the last 5 years, revenue growth has slowed marginally, but nobody could fail to be impressed by the consistent top-line growth of 19% per annum. Unfortunately, non-GAAP operating margins have failed to expand as one might expect - in fact, they've gone into reverse, declining from 36% to 34%. Which is exacerbated by a progressively more generous stock-based compensation policy in the last few years. [Stock-based compensation, or SBC.] Taken together, GAAP operating margin has grown 15% pa. And like most technology companies, stock issuance along the way leaves diluted and excluding-SBC diluted EPS growth at 13-14% pa. Which is not to be sneezed at in a post-crisis world.
But if you weren't an Apple fan (despite its earnings trajectory), you just might hate Alphabet - which boasts lower 5-10 year earnings growth, yet manages to enjoy a far higher multiple! At today's $868.39 share price, Alphabet trades on a 25.3 non-GAAP P/E (based on 2016 ex-SBC diluted EPS of $34.34). And if that turns you off, doubtless you'll focus on the much higher 31.2 GAAP P/E (based on diluted EPS of $27.85). Of course, more adventurous growth investors wouldn't even blink at such numbers. But for the average value investor, on the face of it, these P/Es are likely way too steep to even consider (in absolute, relative, and/or PEG ratio terms).
But such a conclusion could be a huge missed opportunity.
We need to survey the company through different lens - focusing instead on three distinct components of Alphabet's corporate empire, while making one additional but critical accounting adjustment, to apprehend a more realistic picture of the company's performance, prospects, and underlying fair value. First, we have:
A Ton of Cash and Investments:
Too many investors discount cash, while also over-estimating the advantages of debt. [Look at any great growth story, debt is not the driver!]. But a strong balance sheet may permit a more aggressive and longer-term strategy in a company's existing business, whilst also retaining a free option on future growth opportunities. Conversely, an over-leveraged company may quickly find its horizons limited and its options eliminated. Of course, discounting cash (and investments) may still be warranted, if management is intent on: i) building a permanent cushion of idle cash, and/or ii) pursuing illogical and value-destroying acquisitions/investments (or has a history of such indulgence). I don't believe investors face these risks with Alphabet.
In terms of internal investment, Google is the answer - from a single web page, Larry Page and Sergey Brin built a search and advertising colossus from scratch! While also presiding over an acquisition machine, with 200 plus acquisitions since day one. [And here's a fascinating Google timeline.] Notably, the majority of deals have focused on acquiring talent, technology, and intellectual property - not on existing revenues and profits - to support and build on existing businesses, and to expand into related fields. But surveying some of the largest deals, they've been total block-busters: Android in 2005 (for just $50 million), YouTube in 2006 ($1.65 billion), DoubleClick ($3.1 billion) & AdMob ($0.75 billion) in 2007/2009. As for Waze in 2013 ($1 billion), and Nest Labs in 2014 ($3.2 billion), it's still too early to tell.
And Alphabet's largest deal, $12.5 billion for Motorola Mobility in 2011, was also notable: First, it wasn't the failure some have tagged it. Motorola had almost $3 billion of cash at the time, Motorola Home was sold for $2.4 billion, then Motorola Mobility for another $2.9 billion, while deferred tax assets appear to have more than offset interim operating losses. And so, apparently as intended all along, Alphabet effectively acquired Motorola's entire patent portfolio for sub-$3.5 billion, to 'defend the entire Android ecosystem'. Noting Android's smartphone dominance ever since, offence may be the more accurate term than defence!? [By comparison, Apple, Microsoft, and RIM bought Nortel's patent portfolio for $4.5 billion, also in 2011]. And second, the gross consideration for Motorola is actually less than 50% of the annual $26 billion free cash flow Alphabet now generates!
Clearly, Alphabet's current acquisition/investment strategy is value-enhancing, but even snagging a few decacorns won't put a serious dent in its growing cash pile. A step-change in strategy is required - that is, listed and much larger target companies, with revenues, profits, and users being the primary driver. But I'm not convinced that will happen anytime soon - as surely it would require Alphabet to become just a little more evil? ['Evil' is confusing, now I just substitute 'corporate']. Returning cash to shareholders is the obvious alternative. And right now, I'd bet it's a far more likely outcome. And the transition to a holding company structure heralds a greater focus on capital allocation, with Ruth Porat adding an external perspective. [She's called Ruthless Ruth, reflecting the silly notion she's a bull in a china shop. But her hiring was clearly integral to the Alphabet road-map - doubtless, she has Larry and Sergey's full backing. And Larry never liked saying no - now he's got Ruth to do it!] While Alphabet hasn't signaled a dividend, it did complete its first $5 billion plus share buyback in 2015/2016, and recently approved a new $7 billion buyback programme.
Repatriation would be the real catalyst here - to fund, perhaps, a much larger share tender offer - the company now has $52 billion of cash re-invested overseas. I think this was always inevitable, but now appears far more imminent and likely under Trump. [In fact, a 15% (or even higher) tax rate up-front would eliminate a repatriation bill - companies could just take the incremental tax hit. Either way, the tax bill is only a few months of free cash flow for Alphabet]. And speaking of catalysts, it's a brave new world out there for technology companies - activist investors now have an appetite for targeting and harrying even the largest of technology companies to declare a dividend, do a spin-off, buy back shares, or even take on debt.
Meanwhile, Alphabet has $13 billion of cash and $73 billion of securities (primarily in treasuries, sovereign bonds, and agencies). Also: i) $6 billion of investments - any volatility or illiquidity is more than offset by $5 billion plus of unrecorded revaluation gains, ii) $1.4 billion of Lenovo promissory notes due in October - their balance sheet and cash flow suggest no reason to doubt this will be paid, and iii) a recently announced $0.8 billion for a non-controlling stake in Verily - the final tranche to be received in H2-2017. Anyone nit-picking these figures should remember Alphabet is now generating $2.2 billion free cash flow per month! So while we're at it, it's reasonable to also include an additional $5 billion plus of free cash flow year-to-date:
$12.9 Billion Cash + $73.4 Billion Marketable Securities + $5.9 Billion Investments + $1.4 Billion Promissory Note + $0.8 Billion Temasek Deal + $5.3 Billion Free Cash Flow Year-to-Date = $99.7 Billion Total Cash and Investments = $145 Cash and Investments per Share
That's a round $100 billion - like I said, a ton of cash and investments!
Other Bets - Moonshots and Unicorns:
Sequoia Capital, Benchmark, Kleiner Perkins Caufield & Byers, Andreessen Horowitz, Union Square Ventures, Index Ventures, Y Combinator - how many investors would give up their first-born just to invest in these unicorn firms? Yes, they're the some of the best and brightest VC firms in the world, and have the unicorns and IRRs to prove it. At best, you'll face a near-impossible set of hoops (and possibly several layers of fees), to invest in their funds - at worst, it's actually impossible.
So why not consider Alphabet instead?
From day one, Google told its shareholders to expect 'smaller bets in areas that might seem very speculative or even strange when compared to our current businesses'. With the creation of Alphabet, it has now carved out most of these moonshots into a segment called Other Bets - which includes Nest, Google Fiber, Verily, Calico, X, Waymo, GV and Capital G. As any VC worth his IRR will tell you, finding unicorns is all about identifying the best teams (smart, passionate, and experienced founders, managers, and employees), the largest and fastest growing opportunities (the biggest markets and broadest demographics), and then (and only then) the best business model to generate revenue and ideally profits (monetizing needs, wants, and eyeballs). Given Alphabet's record of investment and value-creation to date, its ability to attract many of the smartest and most talented people in the world, its targeting of some of the largest markets on earth (or possibly even space), I'm willing to bet its Other Bets unit may potentially offer one of the best unicorn farms in the world!
And what better confirmation of Page and Brin's faith in these moonshots - they chose to pursue them in-house, regardless of cost (that's now changing). And cost is critical here: Invest in a VC fund, and you will record an asset on your (personal) balance sheet, as would Alphabet making external investments in companies and VC funds. But investing in its own moonshots in-house, the rules dictated it record a pre-tax $3.6 billion P&L loss* last year - not a balance sheet asset! Yes, accounting is sometimes that arbitrary. [*Reflecting Other Bets early-stage revenues, which are fast-growing but still minimal (that is, less than 1% of Alphabet's total revenues), versus its current expense base]. Here's what it looks like over the last 5 years:
Yes, as I'm sure you know, these misleading losses are the culprit behind Alphabet's margin erosion and earnings shortfall (versus top-line growth) over the last 4 years. And while Porat appears to be imposing more budgetary and investment discipline now, I wouldn't necessarily expect much reduction in losses in the near-term - any scaling-back of expense and ambition in one area will likely be redirected into other more promising bets. But as of today, for an Alphabet investor, a cumulative $9.5 billion of Other Bet losses have been fully expensed, but still offers a potentially very valuable free option. And also, ongoing losses should be treated as investment - that is, an asset. Which I suspect presents limited financial risk: Actual cash losses, net of tax, should remain a fraction of overall free cash flow, while ongoing investment is justified if Other Bets can boast, sell, or spin-off a decacorn (say) in the next 3-5 years. [Notably, Snap Inc. (NYSE:SNAP) is a loss-making company which generated $0.4 billion revenue last year (precisely 50% of Other Bets 2016 revenue), but is actually worth $24 billion today!?]
And so, Other Bets losses will be ignored here, with no Other Bets investment asset being created or included for valuation purposes either.
The Cash Machine:
And last but definitely not least, we have the Cash Machine itself, as Googlers sometimes call Google. Having confirmed Alphabet's cash and investments, and re-classified its Other Bets losses as potentially highly valuable VC investments, we can finally evaluate its core business, that is Google's valuation on a stand-alone basis. But we still need to make some minor adjustments, plus one final essential accounting adjustment. First, here's Google's last 5 years:
[NB: Unallocated corporate costs (approximately $0.6 billion per annum) are included here, so revenue and operating income in the Google and Other Bets tables fully reconciles back to the consolidated Alphabet table at the beginning of this post.]
[NB: First table above details Google's advertising segments, then advertising and other segments. While the second table details Google's total revenues, etc.]
What a thing of beauty! Advertising revenue growth from Google's core properties - Search, YouTube, etc. - has averaged 20% pa, despite significant headwinds (annual declines in costs-per-click) from the ongoing transition to mobile. The laggard is revenues from ads placed on external Google Network Members' properties (via AdSense, AdMob, and DoubleClick) - revenue growth has been throttled by the same costs-per-click decline. However, this has been essentially offset by the extraordinarily rapid (49% pa) growth in other revenues, from Google Play (note only net revenue is recorded), hardware sales, Google Cloud services, etc. Google revenues overall have grown 19% pa, which obscures a consistent 20% plus constant currency growth rate (in fact, averaging 22% pa). Again, a general increase in stock-based compensation has marginally reduced operating income growth to 18% pa, noting a stable 31% GAAP operating margin in the last couple of years.
The obvious issue here is whether to focus on GAAP or non-GAAP (that is, ex-SBC) operating income. Wall Street is perfectly comfortable with the latter, and usually I'm happy to ignore stock-based compensation too: On the basis it's a non-cash expense, it vests (or expires) over a number of years, it may be dependent on specific performance and share price targets. Not to mention, as I re-iterate my fair value analysis over time, I'd expect future dilution (unless stock-based compensation is really excessive) to be (more than) offset by future revenue and earnings growth. But in this instance, I'd note the following:
[NB: I had to presume all intangible asset expenditure was acquisition-related, and therefore ignore it in the table above.]
Actual capex substantially exceeds current depreciation and amortization expense - so, despite no stock-based compensation cash cost, Alphabet's free cash flow is only marginally higher than GAAP net income (on average) over the last 5 years. [Obviously, absent this additional capex, free cash flow would be even more impressive!] While we might expect this gap to close over time, it's prudent to focus accordingly on Google's 31% GAAP operating margin (presuming it also corresponds to underlying cash flows). [Note Alphabet just confirmed it will no longer provide non-GAAP earnings (though Wall Street will probably still derive them]. But noting the current growth momentum, we can also anticipate a current revenue and earnings run-rate. While Wall Street is happy to reference 2017 (and even 2018) estimates at this point, I'd normally gross up the latest quarter to arrive at a reasonably conservative annual run-rate. However, Google revenues exhibit a seasonal pattern, rising each quarter to reach a Q4 peak at 29% of annual revenue (I see no operating margin seasonality). Therefore, noting 22% and 24% actual/constant currency growth rates in Q4, let's split the difference twice - that is, use a 23% average growth rate, then halve it - for a conservative 11.5% uplift in revenues. Using the same 31% operating margin, we apply Alphabet's 19% effective tax rate (3 year average), to arrive at:
Which puts Google on revenue of $99.7 billion, precisely equal to total cash and investments (a coincidence Page and Brin would presumably love?), and a net earnings run-rate of $24.6 billion - for an ex-cash 20.2 earnings multiple (remember, this is after stock-based compensation expense).
Unfortunately, we essentially face the same accounting issue here. After centuries of accounting for purely tangible assets and value creation, the accounting profession still refuses to properly appreciate the fact intangible assets have been responsible over the last 50-100 years for an ever-expanding slice of the pie, in terms of economic and corporate value-creation. [Haven't come across a copy yet, but I suspect 'The End of Accounting' is the best read going on this entire topic]. So the vast majority of corporate research and development/intangible asset expenditure continues to be treated as expense, not an investment. Which has its pros and cons: Investors mostly adjust accordingly (that is, they reverse out some or even all of this intangible expense), which explains why intellectual property companies (as in technology, media, pharmaceuticals, etc.) often trade on steep earnings multiples versus the rest of the market. But occasionally, in certain sectors and/or companies, investors seem to lose sight of this earnings suppression - which can throw up some real bargains.
I tend to split the difference by adding-back half a company's intangible expenditures (excluding acquisition-related investment), or possibly two thirds if it has a strong record of innovation and value-creation, to arrive at a more sensible underlying earnings number. Obviously, some R&D/intangibles will never have value, much will have value only for a year or two, but some may turn out to have enduring value for decades to come - my implied amortization, over 2-3 years, seems more appropriate (or maybe even conservative). Again, I enjoy the potential future benefit of all intangible expenditure expensed to date (though bearing in mind some future revenue and earnings decline may occur as historic intangible investment no longer supports or contributes any value).
In this instance, Laszlo Bock's 'Work Rules!' inspired me (far more than Schmidt's 'How Google Works'). Google's famous '20% time' may no longer exist, but as Bock says, that doesn't really matter 'as long as the idea of it exists'. I'll certainly run with that - employees may no longer literally carve out a day each week to mess around with stuff, but Google obviously remains committed to huge investment in its core business, continually ranking and allocating more (or less) resources to products and services which are often still pre-revenue, margin-free, or even plain old loss-making. [YouTube is a prime example - it is, by far, the largest streaming business globally (over 1 billion users per month), but appears to be only in the early innings now of generating revenue, let alone margins. As Google's CEO Sundar Pichai recently stated, 'we believe [it's] only begun to scratch the surface'].
And so, if we treat 20% of operating expense (on average) as intangible investment, we're talking about $13.9 billion. [Disagree with this approach? Note Alphabet's current R&D run-rate is probably about $2 billion higher at $15.7 billion (an average 15.6% of revenue over the last 3 years)]. Then if we back out two thirds of this expense (net), we have:
We arrive at a far more accurate picture of Google's underlying earning power - a 40% adjusted operating margin, and adjusted net income of $32.1 billion, which puts Google trading on an adjusted/ex-cash 15.5 earnings multiple (again, this is after stock-based compensation expense). Which I think is an astonishingly cheap multiple for Alphabet's core business (which still represents over 99% of consolidated revenue), in light of its consistent 22% pa (constant currency) revenue growth in the last 5 years, and its obvious future revenue/earnings potential.
For a minute, compare Google's trajectory to that of Unilever. Now consider this fascinating Lindsell Train analysis (published prior to the Kraft Heinz bid): Investors appear to vastly underestimate the value of consistent compounding - one could have paid a 46 P/E for Unilever 20 years ago, and still have achieved market returns since!
The lesson, of course, is not to focus unduly on the current multiple, or even your fair value estimate - your primary focus should always be on the potential for consistent compounding. Which means getting comfortable with the depth and width of Alphabet's economic moat. Applying one of Buffett's favorite tests is a great place to start:
If I gave you $10s of billions, or maybe even $100 billion, could you take on and beat Google's leading global position in Search?
Google's global share in desktop search is an astonishing 81% - the rest just exist because of China, purchased access/market share deals, and user inertia. Mobile search offers no such places to hide, hence Google's share is a truly astounding 96%. Also being globally dominant in desktop browsers (Chrome, 59%), and mobile operating systems (Android, 67%) have helped protect and grow Google's position. Do you really want to take on that kind of dominance? OK, well it's not just the money, where do you get the people - they probably already work for Google, and a larger compensation package in a brand new search company probably won't entice them. And even if you scrape together a team, what exactly are you going to build from the ground up? What data, queries, etc. are you going to use to help build, test, and improve your search engine? How exactly will you map and access the entire web to feed the beast? How do you plan to roll it out in over 100 different languages? And if somewhere years down the road you're finally ready to go live, how do you actually intend to attract even a small slice of all those captive Google search users?
Wait, I have one more question: What do you think Google was doing while you were holed up in your office for the last few years? Resting on its laurels? I think not. Oh, and did I mention:
'Google' is also a verb.
OK, why not give the money back, eh?
And who better than Charlie Munger to remind us:
'Google has a huge new moat. In fact I've probably never seen such a wide moat.'
That's the beauty of search - its format may change, but the need for search doesn't. In fact, it's fueled by population growth, expanding access to the internet, the continued migration online (and the decline of TV and newspapers), and in turn to mobile and smartphones, and most of all the iterative human addiction for more and more info, answers, and entertainment. Not to mention the network effect of search itself - more searches will produce better searches which produce more searches. [And the same is true of machine learning - the more data, the more input, the more variety, the better the learning - Google's current search remit gives it a huge edge on its potential rivals who are perhaps working with much more specialized data sets/universe.]
Google has built an advertising colossus on the back of this search engine dominance and user growth. Together, Google and Facebook (NASDAQ:FB) now control about two thirds of the digital advertising market, and are essentially sharing all new growth between them. Of course, this is nowhere near being a mature market, with old media still hanging on grimly to a totally disproportionate share of advertising (versus consumers' actual viewing and consumption habits today), mainly due to corporate and ad agency inertia. Which adds another huge tailwind of growth, compounded by the explosion in mobile advertising in just the last few years. There's also a land-grab element to all this: People wring the hands over declining costs-per-click, but that's only natural (and obviously more than offset by clicks paid growth) - increasing the digital advertising pie, and grabbing as large a slice of the pie as possible is what really matters now. And when that finishes, I guarantee you'll see a very different pricing scenario emerge for advertisers.
Then longer term, there's a whole other land-grab ahead: Alphabet's US revenues still represent 47% of total revenues, about double the US share of world GDP - that would suggest huge long term upside growth potential in digital advertising revenues across the rest of the OECD, and particularly in emerging and frontier markets (which are now leap-frogging straight into the digital/smartphone age). Of course, another reason for this is Alphabet's virtual absence from China - a huge untapped opportunity that potentially awaits - if Google was any other company in the world, i.e. just a little bit more evil, they'd buy Baidu (NASDAQ:BIDU) first thing tomorrow morning & justify it (to China - I suspect all other stakeholders would love the deal, or simply not care) as a stand-alone non-integrated acquisition.
Of course, the same story is now unfolding with YouTube. People marvel at the latest user numbers from Spotify and Netflix (NASDAQ:NFLX), but they're totally dwarfed by YouTube's 1 billion plus users, to which it's only recently started to roll out channels, studio-based shows and original content, YouTube Red, Live TV, etc. If you want to target Millennials, or Gen Z, they aren't watching regular TV, and they certainly aren't reading newspapers - the killer app is now video. And, of course, video ads. On your smartphone. Again, I'll highlight this Barron's piece on YouTube - the numbers are really astonishing - but looking at some of the valuations already out there in the market, I can't necessarily disagree YouTube (plus Google Cloud, and possibly other units too) would likely get valued at significantly higher sales multiples than Alphabet currently commands.
In the past, this may have been academic, but now Alphabet has a holding company structure (and also a top Wall Street CFO) that's specifically designed to focus on capital allocation and to empower its units to actually innovate, thrive, and grow as independent entrepreneurial businesses, ideally on a stand-alone basis. And as they grow bigger, and/or head in different directions, Alphabet doesn't necessarily have to grow (or abandon) them any longer - at times, it may make far more sense, in terms of strategy or valuation, to sell or actually spin them off as listed entities (ideally, as unicorns and decacorns!).
And looking ahead, while I still have my doubts whether Alphabet will embrace a step-change in its acquisition strategy (that is, target listed and much larger companies), I'm not sure it matters. We're now getting closer and closer to an always-on world - where computing genuinely does become a utility, like electricity. Almost all of the Google bets and Other Bets are stitching together the potential to provide cloud-based, always connected (via car, mobile, Wi-Fi, Internet of Things), artificial intelligence and machine learning (and even augmented and virtual reality).
For the world, that means universal simultaneous voice translation. For individuals, it means entertainment, education, and personalised assistants. And for corporates, it means predictive data analytics, and cyber-security. Linked to all of this, we have Alphabet's huge moonshot initiatives in autonomous driving, health and life sciences, and the wired home. [Education is the obvious missing moonshot - OK, now there's an acquisition opportunity!] And while I think Google's presided over the most valuable artificial intelligence the world's ever known (forget the actual advertising revenues and benefits, think of the incredible time savings and other benefits the human race derives from search itself every single day!?), I suspect its DeepMind acquisition could eventually prove hugely valuable too. [And the mind boggles if they can also bring quantum computing into the equation].
OK, that's about enough future fun and frolics - now let's pull together a fair value estimate for Alphabet. I promise it'll be painless, all the building blocks are now in place. We already have $100 billion of cash and investments. And we're treating Other Bets losses as venture capital investment (and ignoring all related revenue, losses, and assets). Which only leaves Google - here, I'll average two separate approaches: A growth-based P/E valuation, and a more static and mature P/S valuation.
i) Google has delivered 18% pa operating income growth over the last 5 years, despite significant FX headwinds. I'm pretty confident its economic moat is deep and wide, and its growth prospects over the next few years are as just as good, if not better. You can do the math, look at some of the market multiples, review that Unilever analysis again, but you know that a 30-40 P/E could just as easily be justified (or actually attained, in due course). Stick-in-the-mud I am, I'll limit myself here to a 20.0 P/E fair value multiple, based on the $32 billion adjusted net income I derived above (though I'll assure you, I don't consider that an actual exit multiple).
ii) Mature operating margins of 50-60% plus for Google's core business wouldn't surprise me in the least, but let's stick to the 40% adjusted operating margin I identified above. Which deserves a 5.0 P/S fair value multiple - again, I believe I'm being pretty conservative, in light of some of the market multiples out there for similar high margin (and many lower margin) companies. Obviously, a more mature Google could harness substantial debt capacity cheaply, with essentially zero impact on its market valuation - to fund buybacks, acquisitions, etc. - therefore, let's incorporate some of that capacity into our valuation. To better reflect actual cash flows, this time we'll reference Google's 31% GAAP operating margin: The company could add $91 billion of debt, and comfortably maintain 6.7 times interest coverage (assuming a 5% long-term interest rate) - as usual, I'll apply a conservative 50% haircut & deduct current outstanding debt of $3.9 billion, to arrive at a $42 billion debt capacity adjustment. And so, putting it all together:
$99.7 Billion Cash and Investments + $0 Other Bets + ($99.7 Billion Run-Rate Revenue * 5.0 P/S + $41.7 Billion Debt Adjustment + $32.1 Billion Adjusted Net Income * 20.0 P/E) / 2 = $691 Billion / 688 Million Shares = $1,003.87 Fair Value per Share
Rounding, that's a $1,004 Fair Value per Share, and an Upside Potential of 16%.
Which might seem insane - we've come all this way for 16%?! But again, this fair value estimate is a much less important component of any analysis and investment - it's all about Alphabet's ability to continue growing revenue, and to compound earnings and value. Now, sure, I could map out a 'precise' growth trajectory for Alphabet over the next five years, and a future target share price, but that only offers up a hostage to fortune. And anyway, anybody who wants to buy the shares needs to ponder this trajectory for themselves. Suffice to say, in the next few years, I believe Alphabet will be a compelling investment opportunity under most scenarios. To reference Buffett, you can't buy a great business cheap, but my fair value estimate and upside are a reminder you can occasionally buy a great business at a fair price!
Investors can choose from the Class A shares (GOOGL:US) which have 1 vote per share, and trade at a 2.5% premium (close to the average 2.4% premium since 2014), or the Class C shares (GOOG:US) which have no vote. Some will simply opt for the C shares, and never worry about a premium - fortunately, further share buybacks will target C shares, but conversely they're also Alphabet's future currency for employee compensation and potential acquisitions. As for the A shares, some will argue their votes have no incremental value, since Page, Brin, and Schmidt still have majority control, via the super-voting power of their unlisted B shares. But if you think a dual-share structure is a bit evil, just a touch more evil could see significantly different values attached to each share class in some value-realization event. Then again, what are the chances of such an event? In all likelihood, the outcome for an A shareholder probably isn't any different than a C shareholder - at some point, they eventually sell their shares in the open market, at much the same premium.
As for the charts, they both tell the same message: See here and here. Alphabet shares appear to trace a pattern over the years, alternating between distinct consolidation and rally phases, often lasting 1-2 years at a time. And in terms of that timing, and the current share price, we may be on the verge of a critical departure right now - the shares are currently breaking out to new all-time daily and closing highs. If we do actually see a sustained break higher, I wouldn't be at all surprised to see a $1,000 plus share price melt-up from here, in short order.
I now have an 8.5% portfolio holding in Alphabet Inc., and I specifically own the Class A shares (GOOGL:US).
Alphabet Inc. (GOOGL:US): $868.39 per A Share
Market Cap: $598 Billion
GAAP P/E Ratio: 31.2
Non-GAAP P/E Ratio: 25.3
P/S Ratio: 6.6
Ex-Cash P/S Ratio: 5.5
Target Fair Value: $1,003.87 per Share
Target Market Cap: $691 Billion
Upside Potential: 16%
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. I have no business relationship with any company whose stock is mentioned in this article.