The alphabet value glows after the drop

Despite concerns about the AI ​​revolution, the company’s solid fundamentals, diverse revenue streams and attractive valuation make it attractive

By Kenio Fontes

summary

• The company’s shares look attractive after its recent decline, especially given its double-digit growth prospects and the lowest price-to-earnings ratio among big tech players.
• There are concerns that artificial intelligence will revolutionize Google’s search business, but the company’s diverse revenue streams, including YouTube and Google Cloud, provide stability and growth potential.
• With a solid cash position, high profitability and significant capital investment, Alphabet’s fundamentals remain solid.

When it comes to the Magnificent Seven and big tech stocks, one of the ones I like the least is Alphabet Inc. (GOOGL, Financial) because I think its business model is less attractive and somewhat more fragile compared to Apple Inc. (AAPL, Financial), Amazon.com Inc. (AMZN, Financial) and Microsoft Corp. (MSFT, Financial).

Still, there is no denying that Google’s parent company has its advantages and an excellent operating history.

Given that the company is far from in bad shape, I believe the recent decline in its shares makes them even more attractive and if prospects for double-digit annual growth continue, they are very cheap.

Is the business model at risk?

Looking at the projected prices and earnings of the major Magnificent Seven companies, Alphabet stands out as the one with the lowest multiple. While the search engine trades at 21 times trailing-12-month earnings, companies like Microsoft and Apple are trading at more than 30, not to mention Amazon and Nvidia ( NVDA , Financial ), which further skew the comparison. Even Meta ( META , Financial ), which has had the lowest multiples in recent history, has outpaced the tech giant.

It’s worth noting that while Alphabet has never stood out as a high-multiple stock, it has been much closer to its peers at many points in time, and it’s only in recent months that that gap has become more apparent.

GOOGL Data by GuruFocus

Of course, there’s a reason for that. While the market often functions in dysfunctional ways, it’s unlikely to happen without a credible reason, especially for one of the world’s largest companies. The primary reason the stock is trading at this level, while still expecting double-digit sales growth, is the threat to its core business, Google.

In the second quarter, the search tool accounted for 57% of the group’s revenue, while other initiatives like YouTube, Google Play, and Google Cloud were closer to 10% each. Even with that correlation, you have to give credit to Alphabet, which has built a complete and diversified business model over the years.

Source: App Economy Insights

According to some bears, Google’s search model could be disrupted or slowed down by large language models. Right now, when you want to go to a restaurant or ask a question, the most common thing to do is go to a search engine and type it in. One narrative suggests that this could easily be replaced by asking your chatbot, whether it’s GPT Chat, Alexa, or Siri. If more people start using these other methods instead of searching, search will become less important and will directly impact the company’s revenue.

My approach is skeptical. Regardless of how long it takes for this narrative to materialize, rather than completely disrupting Google Search, it could be something that adds headwinds, limiting growth rather than stagnating or declining that revenue line in the short to medium term. AI will gradually gain traction, but it could take years to reach a significant mass of the population that will adopt it in their daily lives and replace their Google Search habits as a tool.

Because Alphabet is one of the most innovative companies in the world, even if it happens gradually, the company will be able to balance that with growth on other ends, whether it’s cloud, through YouTube, or a new revenue line with Gemini. There are a number of options that bring interesting vision and could help sustain that growth over the long term.

Stick to the basics

In many cases, investors tend to take something simple and turn it into something complex. While this can sometimes be necessary, especially in technology segments that are very dynamic and perspectives change all the time, overcomplicating something and getting carried away by the narrative is a very common mistake.

Trying to look at it pragmatically, in a “stick to the fundamentals” analysis, Alphabet is still an excellent company. The revenue breakdown shows that search and Google Play revenues are up 14% year over year, YouTube is up 13%, and Google Cloud is up 29%. Alphabet is far from a dying business. Even with this growth, the lack of ad revenue on YouTube disappointed the market, which, along with higher capital expenditures, caused the stock to fall after the results.

But that’s not all. In addition to the 10th growth position in the GF Score, its profitability position is also solid at 10. Its financial strength is also very good, with cash on hand exceeding $100 billion. In terms of profitability, it is worth highlighting the net margin of 26.70%, as well as the return on invested capital of 32.50%, which shows the cash cow business model and assertive capital allocation.

What about the future?

Alphabet’s capital allocation is very good, as the company has a solid cash position that could eventually turn into another successful acquisition like YouTube, or reinvest in businesses that are being reshaped to at least remain relevant in industries like search, AI, and cloud. The company made more than $13 billion in capital expenditures in the second quarter to support the robust infrastructure that supports the growth of Google Cloud, Google Search, and other businesses via data centers, but that put pressure on free cash flow.

Moreover, although there is a risk that search will be affected, this is not a trend that is likely to occur in the medium term. As already mentioned, it depends on the mass conversion and adoption of the new tool by the population. In the short and medium term, this technological evolution could bring greater assertiveness to advertising and search, reinforcing this market as a positive trend.

When it comes to competition, while Google recently lost ground to Bing (Microsoft’s search engine), Alphabet still has a virtual monopoly, with over 80% of the search engine market share, according to Statista.

Source: Statista

The future of search is therefore somewhat unclear, but not uncertain enough to call it a dying industry.

Everything has its price

In addition to multiples, which have become even more attractive since the recent decline, other methods confirm that Alphabet stock is at a level that will reward shareholders well. If we run an inverse discounted cash flow model using earnings per share, projecting growth of 15% per year for the next 10 years and 10% for the next decade, we find the current share price by discounting it at a rate of 12%. In other words, if the company manages to achieve greater growth, the annual shareholder return will be over 12%, making the stock a true compounding factor.

The situation becomes even more interesting when we look at the last five years, during which the compound annual growth rate of earnings per share was 25.90%. While the company does not have to maintain this level forever, it is possible that there will be positive surprises along the way, thanks to which the earnings per share growth exceeds the forecasted 10-15% per year.

If we use more reasonable assumptions to try to find a fair price, it’s still possible to find some interesting growth. At 18% in the first 10 years and 8% in the last 10, discounting at 11% (still a high and restrictive number for a company of this quality), we would have a fair value of $212 per share, which equates to 21% growth. I used EPS instead of free cash flow because of the recent history of high capex, which would negatively impact an inverse DCF model.

According to GF Value Line, the stock should be worth around $155, which currently qualifies it as fairly valued, showing that while Alphabet is significantly cheaper than other tech stocks, it is still not a bargain.

Final thoughts

Alphabet still has significant moats and is not a dying business. For this reason, while there is some ambiguity in parts of its business model, the gap between the premium for companies like Apple and Microsoft seems very large, while there is a discount to Google’s parent company stock, making it more attractive, especially after this decline.

Disclosures

I do not have any positions in the stocks listed above and have no plans to purchase new positions in the stocks listed above in the next 72 hours.