Alphabet Stock: My Best Market Risk-Reward Opportunity

Alphabet Stock

Alphabet Stock (NASDAQ:GOOGL) is an unexpected casualty of the tech stock crash. Even though Google is a tech stock, you might have thought that its long-term growth, high-profit margins, and $116 billion in cash would have helped the stock price. None of that helped when the stock fell after earnings for the third quarter. While the market keeps focusing on short-term problems with growth and profits, I’m looking ahead to a time when both growth rates and operating leverage will improve. This company has always put a lot of money into long-term growth, and I expect to see the results of those investments even in a challenging macro environment. Because the stock is trading at a good price, this is one of my best ideas on the market right now.

Alphabet Stock Price

Google stock has dropped by 40% from its recent highs. If people used to think that Alphabet was a “safe” stock to own in the tech sector, that idea has been seriously questioned.

The last time I talked about the stock was in December, when I said it was a strong buy because Google Cloud had a lot of hidden value. Since then, the stock has lost 12% of its value, which is strange because it has a lot of good qualities.

How to Value Alphabet Stock

After growing sales by 41% in the third quarter of 2021, Alphabet’s top-line growth was only 6%, but it was 11% when the dollar value was held constant. Even though the headline number for earnings per share (EPS) shows a 24% drop, we should consider non-cash unrealized investment gains and losses. After that change, earnings per share stayed the same from year to year, at $1.24.

Alphabet’s income from ads on YouTube went down year over year, but Google Cloud still grew by 37.6%. Even though sales went up, operating income decreased because the company kept investing in growth. Headcount went up 24.5% year over year and 7.4% sequentially.

Even though Google Cloud’s operating losses went up only slightly, both Google Services and Other Bets saw some of their margins shrink.

At the end of the quarter, Alphabet had $116.3 billion in cash and owed $14.7 billion. The company showed that it was still committed to giving cash back to shareholders by making $16.1 billion in free cash flow and buying back $12.6 billion in shares.

On the conference call, management said that they were “realigning resources to invest in [their] biggest growth opportunities,” moving away from “lower priority efforts to fuel higher growth priorities.” In the third quarter, management said they expected the number of new employees to be lower in the fourth quarter. From how the market reacted to the report, Wall Street was hoping for more drastic cost cuts instead of a slowdown in the growth of costs.

Foreign exchange is expected to hurt even more in the fourth quarter, adding to the short-term problems caused by the tough macro environment and comparisons to last year.

Should I Buy, Sell, or Hold Alphabet Stock

At its current price, Alphabet was only worth 18 times its earnings. I’ll show you in a moment why the stock is even cheaper than that, but even at that multiple, the stock looks too cheap when you consider that most people expect earnings to grow by more than 10% each year.

Earnings expectations also need to be higher since they only take into account a small amount of operating leverage.

Management acknowledged that the environment was harsh and said that the way they would deal with it was to “set up for the next decade of growth.” On a side note, investors don’t fully understand how cost rationalization at tech companies today will help them in the long run.

In Google Cloud, management said customers are taking longer to sign deals and signing for shorter or smaller deals. Many investors may be disappointed that Google Cloud doesn’t have operating profits, especially compared to Amazon Web Services (NASDAQ:AMZN), which has strong margins. However, management has said that while they are still “very focused” on profitability and free cash flow, they are putting more money into the long-term opportunity.

As usual, an Alphabet should be valued based on how much its parts are worth together. The stock is worth 18 times its earnings, but the net cash position of $111.6 billion is worth $8.52 per share. Taking into account net cash, shares are worth 16.5 times their earnings. But that earnings valuation gives a negative value to the Google Cloud and Other Bets divisions, which lose money. To be safe, we can provide Other Bets a value of $0, even though its long-term value may be relatively high because it is home to Waymo and other important things. Over the long term, Google Cloud will have a net margin of 30%. Assuming 30% growth and a “PEG ratio” of 1.5x price to earnings growth, I think the fair value is 13.5x sales, or $373 billion. That means that each share is worth $28.50. 

I believe that Google Services, which includes search, ads, and YouTube, will grow at a 10% rate over the long term. Using a 1.5x PEG ratio and assuming long-term net margins of 40%, it’s worth 6x sales, or $1.48 trillion ($112.70 per share), which is six times the company’s sales. When we add these up, we get a $150 per share value. Alphabet will be worth much more than that, as a 2x to 2.5x PEG ratio seems more appropriate given its strong moats and attractive long-term growth.

What are the key risks? Alphabet is already a huge company, so the law of large numbers may kick in at some point and stop Google Services from growing. I find that hard to believe because this market segment still benefits from how digital usage and digital transformation work together. 

Even though Alphabet is in charge of its Android devices, it could be hurt by Apple (NASDAQ:AAPL) as the company moves forward with its advertising plans. A risk that may be considered less than it should be is that the government might take action against the company because of its monopolistic nature and how it uses data. I want to point out that I’m less worried about macro risks in the near future because the company’s strong cash flow and balance sheet should help it weather the storm.

The best way to take advantage of the tech crash is to buy a basket of tech stocks that have been hit hard. It’s a good idea to buy Google stock, as I rate it as a Strong Buy.

Featured Image: Megapixl @ Rafaelhenriquepress 

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About the author: Stephanie Bedard-Chateauneuf has over four years of experience writing financial content for various websites. Over the years, Stephanie has covered various industries, with a primary focus on consumer stocks, cannabis stocks, tech stocks, and personal finance. This stock lover likes to invest for the long-term. Stephanie has an MBA in finance.