This article analyzes Alphabet Inc. (NASDAQ:GOOG)(NASDAQ:GOOGL) with a focus on its profit sustainability and scalability. This analysis examines the two most important aspects of profit Sustainability: return on capital employed (“ROCE”) and marginal return on capital employed (“MROCE”). To me, ROCE and MROCE are the two most important metrics for analyzing a business. They reveal the two most fundamental aspects of the same central issue of profit sustainability. ROCE tells us how profitable the business has been or is SO FAR. And MROCE sheds insights into which direction the profitability is likely to go.
The results show that even though GOOG earns a remarkably high ROCE in the past, it is starting to enter a stage of diminishing return. Warren Buffett likes to say that interest rate acts like gravity on all economic activities. Well, diminishing returns act like gravity on all economic activities too, if not more so. Even a business like GOOG, with a business model that is intuitively perfectly scalable, can be subject to this force of gravity as shown by the MROCE results in recent years. Lastly, this article also discusses its valuation, especially valuation adjusted for ROCE and valuation compared to the other FAAMG stocks. And the results suggest that its valuation is in the middle range of the FAAMG pack.
Google derives more than 80% of its revenue from advertising, but it is not an advertising company. Its true moat is in its “free” search services, where it totally dominates, as seen in the chart below. As seen, Google has been maintaining nearly 90% market share of the global search traffic – and it has been maintaining such dominance for OVER A DECADE!
Furthermore, it is unlikely that such dominance would change in the future (barring any major regulation or antitrust legislation change) due to the so-called “network effects”. The network effects refer to the fact that the value of certain products or services increases as more people use them. In other words, certain networks become increasingly more valuable as they become bigger – at least to a certain point.
There is nothing new about the concept. It was true of railways, telephones, and fax machines. All these examples share these common traits: A) the larger the network becomes, the more valuable it becomes (one segment of a railway linking city A and B is far more valuable when this segment also links to other railways linking other cities); and B) the larger the network becomes, the higher the switching cost (if everyone uses a fax machine and you do not want to use one, good luck to you).
Unfortunately, like all good things eventually run to an end, so do the benefits of the above network effects. At some point, gravity always catches up, and return begins to diminish. In the railway example, if enough railways have already been built to link all cities with high population density, building the next segment would suffer a diminished return now. In the fax machine example, if every office already has one, adding a second one to each office would also suffer a diminished return.
Therefore, as investors, we do not only need to examine the ROCE, but also equally importantly, to examine the marginal return. Because the marginal return tells us if the business is still in a scalable stage, or if the business has already passed the tipping point of scalability and begins to see a diminishing return. In another word, MROCE let us see if the gravity of diminishing return has caught up yet or not.
In theory, one would intuitively expect the services GOOG provides to enjoy the benefit of perfect scalability. Intuitively, GOOG’s business model benefits from a self-sustaining positive feedback loop: more users in this network will lead to more relevant and accurate recommended contents, search results, and ad placements; which will make the network even better and more valuable for its users and clients; which will, in turn, attract more new users and clients to join and make it harder for existing users to leave; which again will lead back to more users and an even larger network.
If you share the same intuition, then you are in for a surprise by the results in this article. The MROCE results in recent years show that the gravity of diminishing return is catching up on GOOG.
Let’s first address ROCE. ROCE stands for the return on capital employed. Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how effectively the business uses its capital to earn a profit. For businesses like GOOG, I consider the following items capital actually employed:
1. Working capital, including payables, receivables, inventory. These are the capitals required for the daily operation of their businesses.
2. Gross Property, Plant, and Equipment. These are the capitals required to actually conduct business and manufacture their products.
3. Research and development expenses (an essential expense for a business like GOOG).
Based on the above considerations, the ROCE of GOOG over the past decade is shown below. As seen, it was able to maintain a respectably high ROCE over the past decade: on average ~55% for the past decade. To put things in perspective, the next chart compares GOOG’s ROCE against the other FAAMG stocks. As can be seen, GOOG earns a very competitive ROCE among them. Every $1 of earning reinvested will fuel an additional $0.55 of future earnings growth.
Source: Author and Seeking Alpha.
Source: author and Seeking Alpha.
In addition to ROCE, an equally important concept is the marginal return on capital employed (“MROCE”). To me, ROCE and MROCE are the most two important metrics for analyzing a business. They reveal the most fundamental two aspects of the same central issue of profitability. ROCE tells us how profitable the business has been or is SO FAR. And MROCE sheds insights into which direction the profitability is likely to go.
A bit of background and introduction for readers who are new to the concept. For readers familiar with the concept already, definitely skip this section. From what I’ve learned, the legendary economist John Maynard Keynes first explicitly expressed this concept, although people before him have observed and thought about it for some time already. What the concept tries to capture is a basic law in economic activities: the law of diminishing returns. Warren Buffett likes to say that interest rate acts like gravity on all economic activities. Well, diminishing returns act like gravity on all economic activities too, if not more so, as long as human nature does not change in any fundamental way.
The next chart illustrates the concept. As long as shareholders are seeking profit, a public business will first invest its money at projects with the highest possible rate of return (i.e., picking the lowest hanging apples first or getting the most bang for the buck first). Therefore, the first batch of available resources is invested at a high rate of return – the highest the business can possibly identify. The second batch of money will have to be invested at a somewhat lower rate of return since the best ideas have been taken by the first batch of resources already, and so on. The last batch of money invested may earn a rate of return that is only above the cost of capital. And finally, the end result is a declining MROCE curve as shown.
The ROCE we normally talk about and companies report refers to the average of this curve – averaging the return on all batches of money invested. Obviously, the average is very useful information by itself. It tells us how efficiently the business has been converting resources into profit so far – but its limitation is that it only tells us the efficiency of the resources that have already been invested SO FAR. What is of equal importance to investors is the MROCE, which tells us how much incremental profit the business WILL generate when the next batch of resources are invested.
For investors, a dream business to invest in would be a business that enjoys a flat MROCE curve as shown by the solid blue line. This would be a business that is perfectly scalable. A business that earns a consistent and stable profit for every batch of resources invested. However, such a business is really only a dream business. I mentioned earlier that diminishing returns act like gravity on all economic activities – because they really do. There has been no business (at least not so far in human history) that can keep growing while at the same time maintaining a constant return on capital. At some point, gravity always catches up and the return begins to decline (as shown by the dashed blue line).
So for investors, the next best deal is to invest in a business that A) has a high and stable ROCE, and B) that is still in the scalable stage (the gravity of diminishing return has not caught up yet). Unfortunately, as shown in the next chart, GOOG seems to have passed the tipping point of scalability and begin to see a diminishing return in recent years.
This chart shows the MROCE and ROCE for GOOG over recent years. The ROCE data are the same as those shown in the previous section. The MROCE data are estimated by the following steps. First, the capital employed was calculated for each year. Second, the earnings were calculated each year. Third, then the incremental of capital employed year over year was calculated. Similarly, the incremental earnings year over year were also calculated. And finally, the ratio between the incremental earnings and incremental capital employed was calculated to approximate the MROCE. During years when there were large fluctuations in either the incremental earnings or the capital employed, a multi-year running average was taken to smooth the fluctuations.
The results shown in the following chart show that at this stage, GOOG has been maintaining an MROCE that is noticeably below the average ROCE. As seen, the ROCE has been on average 54.8% in recent years, and the MROCE has been on average 40.2%. And the difference is more than 14%, too large to be caused by the uncertainties in the financial data and rounding off errors. So this result suggests that GOOG has started entering a stage of diminishing return – gravity is beginning to catch up. And if the current MROCE continues, GOOG’s ROCE will gradually decline from its current level.
Source: author and Seeking Alpha data.
After the above discussion of its profitability sustainability, let’s look at the valuation. As can be seen from the following numbers in the chart, at its current price levels, GOOG’s FW PE is about 28x, the lowest among the FAAMG pack. Although the FAAMG pack is currently valued at the same level in terms of PE except for AMZN anyway, so the comparison of PE of this pack to me is really not that interesting.
For me, what is more interesting is the valuation adjusted for quality. The next chart compares GOOG’s valuation adjusted for its ROCE with its peers. It is not that meaningful to discuss valuation in isolation and without adjusting for the quality of the business. Therefore, this chart shows the valuation adjusted for ROCE by simply dividing the PE by the ROCE. As seen, now GOOG is more toward the expensive end of the FAAMG pack when adjusted for ROCE.
Source: author and Seeking Alpha data.
Source: author and Seeking Alpha data.
This article analyzes GOOG with a focus on the most two important aspects of profit sustainability: ROCE and MROCE. These are the most two important metrics for analyzing a business because ROCE tells us how profitable the business has been or is SO FAR, and MROCE sheds insights into which direction the profitability is likely to go. The results from this analysis show that:
Thanks for reading! Look forward to your comments and thoughts!
This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
** Diverse background and holistic approach
Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities.
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Disclosure: I/we have a beneficial long position in the shares of AAPL 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.