• Willow Oak Advisory

Alphabet: Strikingly Undervalued


  • Based on eMarketer’s latest forecast and the trend it assumes, in the next 10 years, global digital ad spending will exceed $650 billion.

  • This allows predicting Alphabet’s revenue will grow at a CAGR of 13% in the coming 10 years.

  • Most likely, the operating margin of Alphabet will moderately decline.

  • Based on these key assumptions, the DCF model clearly indicates a growth potential of Alphabet’s shares.

Investment Thesis (Seeking Alpha)

The DCF valuation of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), based on the conservative prediction parameters, indicates more than 40% growth potential of the company’s stock price.

When performing DCF modeling, the greatest attention must be paid to the revenue forecast of the company. So, let's start with that.

According to the latest financial report, Google was accountable for 99% of Alphabet’s revenue. In turn, 85% of Google’s revenue was brought by advertising. The remaining 15% was provided by "Other" activities (cloud offerings, digital content in the Google Play store, apps, hardware and others). This proportion is not constant and if the current dynamic continues, by the year 2028, the non-advertising revenue of Google will amount to 26%, while the advertising - to 74% of the total revenue, which will still be a substantial part of Google's revenue.

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

According to eMarketer’s latest forecast:

Despite early warning signs of a global economic slowdown, the possibility of a recession is not keeping most advertisers up at night. Ad spending will continue to rise across the globe, with digital driving most of the growth... In 2019, worldwide digital ad spending will rise by 17.6% to $333.25 billion. That means that, for the first time, digital will account for roughly half of the global ad market:

Given that my DCF model uses Alphabet’s revenue forecast for 10 years, I "extended" eMarketer forecast until the year 2028:

Judging by the data from the past five years, the growth of Google outstrips the growth of the global digital ad market as a whole, and I see no reasons for the situation to change in the next decade. Therefore, I assume that the CAGR of Alphabet’s revenue in the next 10 years will amount to 12.9%:

It is noteworthy that these figures match the average analysts' expectations:

Moving on. I expect that Alphabet’s operating margin for the next 10 years will gradually reduce to 18%. This is due to the fact that the digital advertising market is becoming more competitive:

The tax rate is assumed to be 25%, which is the world's average and corresponds to the average Alphabet’s indicator over the previous 5 years:

The model involves a gradual decrease in the relative size of CAPEX from 18.4% in 2018 down to a more adequate 17% in a terminal year:

Here is the calculation of the weighted average cost of capital (WACC):

Some explanations:

  1. I used the current yield of UST10 as a risk-free rate and an equity risk premium of 5.96%.

  2. I used the current value of the 1-year beta coefficient. Building the model, I proceed from the assumption that, the beta coefficient will drop from its current highs, which would entail lowering of the WACC.

Here's the model itself:

So, the DCF-based target price of Alphabet's shares is $1765, offering 43% upside.

Bottom line

I like to repeat, that the stock market is best associated with a pendulum. It's rarely balanced, but inevitably comes back to the balanced state from time to time. And, as was shown, the balanced or rational state of Alphabet's price is much higher than its current price.

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