Valuation Of Alphabet Must Treat 'Other Bets' As An Option

| About: Alphabet Inc. (GOOG)

Summary

Penalizing Alphabet's valuation for the negative NPV of Other Bets results in undervaluation as it ignores the optionality value of Other Bets.

Other Bets should be valued as a call option as it gives management the option to either participate in its upside potentials or to lose the premiums paid.

Even if Other Bets currently has $0 intrinsic value, it still has a positive time value from future profit possibilities.

The Alphabet valuation formula: value(alphabet) = value(Google) + MAX(value[Other Bets],0).

Alphabet Inc. (GOOGL, GOOG) consists of business segments such as Google and Other Bets. Google is the company's main business and cash generator, while Other Bets includes the company's cash-burning projects such as Waymo, DeepMind, Nest, etc.

In fiscal 2016, the two segments had the following operating results:

Google

  • Revenue: $89.5 billion
  • Operating Income: $27.9 billion

Other Bets

  • Revenue: $0.8 billion
  • Operating Income: -$3.6 billion

When valuing Alphabet, it is natural to penalize the company's overall valuation by the negative NPV of Other Bets. However, this assumption underestimates Alphabet's actual value as it ignores the optionality value of Other Bets.

The following scenario demonstrates the flaws of not accounting for Other Bets' optionality value:

  • Suppose that Google has a NPV of $500 billion and Other Bets has a NPV of -$50 billion Alphabet therefore would have a NPV of $500 - $50 = $450 billion.
  • An acquirer can buy Alphabet for $450 billion, immediately discontinue Other Bets, and be left with just Google (value of Google is not impacted as Other Bets is operationally and strategically independent from Google).
  • The acquirer can then sell Google and make a risk-free profit of $500 - $450 = $50 billion.

If an asset is accurately valued, it should not create a situation in which arbitrage profit is possible. Instead, Other Bets should be valued as a call option:

  • Alphabet pays a premium (Other Bets' operating expense plus cost of funds) to long the call (the right to own the future profit of Other Bets).
  • If management decides that Other Bets will not be profitable, they can terminate Other Bets and lose only the premiums paid.
  • If management decides that Other Bets will be profitable, they can continue to pay the premium until it achieves positive NPV.

Therefore, the option to terminate Other Bets with no negative consequences to Google means that the Alphabet should be worth at least the value of Google.

Furthermore, even though Other Bets may currently have a negative NPV doesn't mean that in the future it will remains so. There is time value from the possibility that these side projects will become profitable in the future. Therefore, even though Other Bets may currently have an intrinsic value of zero, it still has a positive time value, which would result in an overall positive option value.

Given these observations, the value of Alphabet should be calculated using the following formula:

value(Alphabet) = value(Google) + MAX(value[Other Bets],0)

The Monte Carlo options model is the most suitable for the valuation of Other Bets as it can account for multiple sources of uncertainties and complexities generated by the various companies within Other Bets.

Due to the difficulties in valuing Other Bets, it is more practical and prudent to simply assume that the valuation of Alphabet is equal to the valuation of Google. This removes the uncertainties created by Other Bets and focuses solely on the primary business of Alphabet.

It is uncertain whether this valuation method of Alphabet is currently priced into the market or not. But if it is not, it implies that the shares of Alphabet may be more discounted than currently priced.

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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