Alphabet: Comprehensive Valuation Update

Summary

• Technically, a look at the dynamics of Alphabet shares does not indicate the formation of a bubble.
• Judging from the multiples, Alphabet is not overvalued.
• DCF modeling indicates steady growth potential of the company's capitalization, but with reservations.

Investment Thesis

A comprehensive valuation of Alphabet (NASDAQ:NASDAQ:GOOG) (NASDAQ:NASDAQ:GOOGL) indicates the preservation of the long-term growth potential. In the short term, Alphabet is at risk.

To begin with, I’ll say a few words about Alphabet in the context of the technical parameters of the dynamics of its shares.

Distribution of the monthly return on Alphabet’s shares fits within the standard distribution. This indicates the predictability of the long-term results. However, Alphabet’s coefficient of variation is perhaps the highest compared to that of other companies from the FAAMG list. This means that Alphabet’s investors take a relatively high risk with every percent of the average rate of return.

Over the past two years, the monthly return on Alphabet’s shares did not extend beyond the lower standard deviation. February's results also fit within these limits:

The long-term dynamic of Alphabet’s shares is well described by the exponential trend that appears as a straight line on the graph with a logarithmic y-axis. This is sort of a test for the signs of the formation of a bubble.

Now let’s talk about the multiples.

In the Q4, the EPS (ttm) of Alphabet fell by 35.64% YOY due to the one-time tax payment. The company gave the following comment:

The Tax Act was enacted on December 22, 2017 and resulted in additional tax expense of $9.9 billion in the fourth quarter of 2017 primarily due to the one-time transition tax on accumulated foreign subsidiary earnings and deferred tax impacts.

Due to the technical reasons for the decline of Alphabet’s earnings, now we obviously should not pay attention to its multiples based on the current values of the company's earnings. Instead, let’s focus on the EBITDA, P/E (forward) and P/S (forward).

The direct comparison of Alphabet’s multiples with those of its main competitors indicates a clear underestimation of the company:

It is noteworthy that when we assess Alphabet in this manner, not sticking to the industry, we come to the conclusion that the company is approximately fairly valued by the market:

If we revisit Alphabet’s key competitors and compare them using the P/E and P/S multiples, adjusted for the expected growth of earnings and sales, we’ll get a less unambiguous result: Alphabet is overvalued on the P/E to growth (forward) multiple and is close to a balanced state of the P/S to growth (forward) multiple:

Comparison with a broader range of companies gives a more optimistic result: balanced assessment on the P/E to growth (forward) and potential for growth on the P/S to growth (forward):

So, judging by the multiples, you can say that Alphabet is at least not overestimated if the market is inclined to evaluate this company based on the parameters of the expected revenues, and not profits.

Now let's see what has had more influence on Alphabet’s capitalization lately: the parameters of revenue or profit?

Starting from 2004, Alphabet has been demonstrating a strong relationship (R^2=0.74) between the EV/EBITDA multiple and the annual growth rate of EBITDA:

However, if we only consider the dynamics for the last two years, the relationship between these indicators almost does not exist (R^2=0.1):

On the other hand, Alphabet also demonstrates the long-term relationship between the EV/Sales and the annual revenue growth:

And in this case, this relationship preserved and even increased in the last two years:

As you can see, over the past two years, Alphabet’s revenue growth influenced its capitalization more than the EBITDA growth. It means that assessing Alphabet we should pay great attention to the P/S. And it says, as shown above, that Alphabet is at least not overvalued.

Now let's see what the DCF analysis says.

99% of Alphabet’s revenue comes from Google. The remaining 1% comes from other activities, which may be disregarded within the present analysis.

According to the results of 2017, 88.2% of Google’s revenue was brought by advertising. The remaining 11.8% was provided by activities, merged in the report under the name "Other" (cloud offerings, Google Play, apps, hardware and others). But, this proportion is not constant. If the current dynamic continues, by the year 2027, the non-advertising revenue of Google will amount to 25%, while the advertising - to 75% of the total revenue.

But anyway, it is important to forecast Google’s revenue taking into account the global trends of digital advertising.

Based on current projections, I expect that digital ad spending worldwide over the next ten years will grow at the CAGR of almost 10%.

Examining the most conservative scenario, I assume that the CAGR of Alphabet’s revenue in the next 10 years will amount to 11.4%:

Here is the calculation of the WACC:

Note that I used the value of the two-year rolling beta coefficient in my calculations.

Later, I'll show you in detail how the Beta affects the WACC and the overall result of the modeling.

The model involves maintaining the tax rate at the level of 26%.

I went by the assumptions that Alphabet's operating margin will gradually reduce to 20% because this is consistent with the long-term trend of this indicator:

GOOGL Operating Margin (TTM) data by YCharts

The relative size of CAPEX will gradually increase to 14%, which is above the medium historical indicators of Alphabet.

GOOGL CAPEX To Revenue (TTM) data by YCharts

Here's the model itself:

So, the DCF-based target price of Alphabet's shares is $1568, offering 45% upside.

The result of the model is most sensitive to the WACC, which, in turn, is very sensitive to the value of the Beta and the CAGR of the revenue.

Therefore, I present two sensitivity tables.

The first one shows the dependence of the WACC on the Beta:

And the second one demonstrates the dependence of the fair price within the model based on the WACC and the CAGR of the revenue.

Putting It All Together

Alphabet, just as the entire U.S. stock market, had a difficult beginning of the year 2018, but it is not going beyond the healthy correction so far.

Multiples are not as unambiguous as those of Facebook (FB), for example, but they do not indicate an overvalued state.

The DCF-modeling indicates the growth potential even with the most pessimistic input parameters, but under the condition that the Beta will be lower than its multiyear highs. A high Beta indicator is now typical for many companies pointing to a risk of increased volatility, which puts pressure on the market.

I believe that Alphabet still retains the "strong buy" status, but only for long-term investors. Under the high risk of the second wave of the market decline, Alphabet’s shares, that strongly correlate with it, may go below $1000 for a short period of time.

Analyst’s 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.