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In recent months, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) shares have come down more than 30% since their all-time high. In late November of 2021 the stock hit $3,042, and as I am writing it is trading at $2,113. After dropping more than 5% on Tuesday, it is doing as badly as the Nasdaq Composite index, which at 11,250 points is also just over 30% below its high of 16,212.
It is no secret that tech is a growth-heavy industry, where valuations have suffered more than average from inflation and the prospect of rising interest rates. At this point we all wish we could predict where the bottom is and whether the economy, inflation or interest rates are going to go better or worse than current expectations. My aim in this article, however, is to compare the parent company of Google with the communications sector overall to argue that it is relatively undervalued. For this analysis I am going to focus on the price to earnings ratio and revenue growth.
As you can see, Alphabet is priced higher than the sector median in terms of earnings, but cheaper than the sector median if we look at the PEG ratio, which takes into account earnings growth. If we take the measure in which Alphabet is most expensive, the TTM non-GAAP, it is 39% more expensive than the sector median. I am going to explain why we like to use revenue growth instead of earnings growth to adjust the valuation, and why I believe that even taking the most pessimistic view, Alphabet is fairly valued in relation to the communication services sector, while a more moderate analysis indicates that is relatively cheap.
Every company is a different story, and we have to adapt our analysis to each case, but they nearly all have in common that earnings growth is a much more volatile measure than revenue growth. Take a look at Alphabet’s figures in the last nine years:
There are cases where revenue growth does not paint the whole picture. When a company is at the start of its growth cycle it is often not profitable, so we tend to look at sales. When the company breaks into profitability, margins tend to increase over time and earnings grow faster than sales, so their growth becomes relevant. However, this process is limited and eventually the expected margin will stabilize when the company is more established. When this happens, by simply fluctuating more, the earnings give us an unnecessarily volatile measure of growth. This is the point where we find Alphabet. The Net income margin was unusually low in 2017 (12%) and unusually high in 2021 (30%), but other than that it has fluctuated between 21-24% over the last 10 years.
Other than the pure fact of valuation multiples eroding because of higher interest rates, there could be an element of concern that Alphabet’s growth is slowing down. That depends on what timeframe you measure the growth in. I often say that using latest year-on-year rates as the only measure of growth and drawing all conclusions from that makes expectations fluctuate too much.
If we look at the bigger picture, growing companies usually offer quite a reliable long-term pattern of growing revenues, with individual years moving slightly above or slightly below the trend. Most companies show a trend of diminishing growth rates, but a few of them, such as Alphabet, have a revenue history that is consistent with exponential growth. That means a constant growth rate. The chart below shows you this trend, which predicts a long-term CAGR of 20.18%.
Items in $M (Author’s work)
As you can see, the year 2021 saw exceptionally high sales. This made it more likely that 2022 would be “disappointing” in terms of the growth rate. Despite that, the company has grown 23% year on year in the first quarter, which is still above the long-term rate, despite having already grown 34% in the first quarter of 2021.
If we compare Alphabet to the sector median, it is growing almost 3 times faster:
The year-on-year rate, which takes into account the trailing twelve months as of the latest quarter is where the difference is highest thanks to an exceptional 2021, but even the forward figure, which is based on consensus estimates and much closer to what we have determined to be the expected growth rate in the long run, is 167% higher.
Let’s assume Alphabet’s natural growth rate is 20.18%, less than in the last couple of years, but the current sector median growth rate of 12.76% is sustainable over time. What I am going to do is compare Alphabet to a hypothetical sector median company to see how your share of earnings would evolve in each case. Let’s consider that Alphabet’s PE ratio is 39% higher than the sector median.
Imagine you invest in a “sector median” share that represents $1 of yearly earnings. Given the sector PE ratio of 14.52, this should cost you $14.52. The same amount invested in Alphabet shares, with a PE ratio of 20.20, would entitle you to just 72 cents of earnings. These earnings will increase by 20.18% each year while the sector median earnings would grow 17.76%. I am going to apply a five-year rule, so the company where you get the best result in 2026 is the best. Here is a table showing how it would evolve:
With these pessimistic assumptions, Alphabet is very close to the correct price. For the share to give you the same earnings in 2026 the price would need to be $2094 instead of the current $2113.
A more realistic approach is to assume that Alphabet is not the only company in the communications sector that has been punching above its weight in growth terms in 2021, so the slowdown as we return to the normal trend is generalized. This is supported by the fact that forward growth rates for the sector are lower than current ones in about the same proportion as Alphabet’s. I am going to assume that as Alphabet’s growth goes from 37.54% to 20.18%, the sector median growth goes from 12.76% to 6.88%.
In this scenario, Alphabet gives you higher earnings in just three years thanks to its superior growth. For 2026 earnings to be the same, the price of Alphabet shares would have to be $2742. That is 30% higher than the current price.
Although this is by no means a definitive method of valuation, I believe it does make the case that Alphabet shares are much more likely to be undervalued than overvalued when compared to the communications sector in general. This doesn’t mean the price will necessarily go up in the short run.
There are two main factors that make me think the price could go down further. On one hand the current fate of technology stocks is grim, and nobody really knows for sure where the bottom is. On the other hand, above-trend revenues in recent periods may continue to create the false impression of a long-term revenue growth slowdown as sales return to their original trend. This could lead the company to become further undervalued.
Regardless of these factors, I think Alphabet at today’s price is a fantastic long-term investment with plenty more upside than downside.
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Disclosure: I/we have a beneficial long position in the shares of GOOG either through stock ownership, options, or other derivatives. 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.