Source: PaxForex Premium Analytics Portal, Fundamental Insight
The year 2022 saw a general decline in the value of stocks. As the U.S. market fell about 15% and many individual stocks fell much more, investors had an opportunity to invest profitably in high-quality companies. Alphabet, the parent company of Google, YouTube, and Google Cloud are perfect examples of this. The stock price to EBIT (earnings before interest and taxes) ratio has fallen to one of its lowest levels in 10 years, due to a 27 percent decline in share price since the beginning of the year combined with continued earnings growth.
This discounted valuation of Alphabet stock provides a great opportunity for investors. Here's how the stock could double over the next five years from today's prices.
Excluding periods of time when the business was affected by coronavirus disruptions, Alphabet has managed to steadily grow earnings by about 20% over the past 10 years. The company now has annual sales of $256.7 billion, making it one of the largest businesses in the world.
Although the company's business is huge, Alphabet's revenues should continue to grow at 10%+ per year for several reasons. First, Google Search and Alphabet's other advertising segments still have great potential for growth, especially internationally. With 2.8 billion Android smartphone users worldwide, Google has an easy path to maintain its search market share as more and more people become regular Internet users around the world. Google search is Alphabet's most important segment, accounting for more than half of its revenue last quarter.
In addition to search and Google's other advertising products, Alphabet's YouTube and Google Cloud segments have tremendous growth prospects over the next five years. YouTube has approximately 2.5 billion active users, making it one of the most used Internet services worldwide. It is also extremely popular among young people: 95% of American teenagers said they use it regularly. The app generates "only" $7.3 billion in quarterly revenue, 10% of Alphabet's sales, but has great potential for monetization due to its huge user base.
Google Cloud is one of the three largest cloud infrastructure providers in the U.S. (along with Amazon Web Services and Microsoft Azure). Last quarter, this segment generated $6.3 billion in revenues and is growing 35.6% year over year. Third-party analysts expect the cloud computing market to grow about 15% a year over the next five years, if not longer. If Google Cloud maintains or increases its market share, this segment will be a strong growth area for Alphabet for years to come.
Steady double-digit revenue growth is great, but for the stock to double in five years, Alphabet needs its profitability and free cash flow to grow even faster. Fortunately, the company has some easy ways to get operating leverage and grow margins over the next few years.
Alphabet currently has an operating margin of just under 30 percent and a free cash flow margin of 23.4 percent. Those are impressive numbers, but they look even better when you realize how much the company has reinvested in growth. Google Cloud had an operating loss of almost $1 billion last quarter, and this company is very capital intensive (you have to build a lot of data centers before customers start paying for services). The Other Stakes division burns more than $1.5 billion a quarter while generating minimal sales. Alphabet also has 174,000 employees, with about 30,000 new hires in the past 12 months.
Company executives have said they will reduce or slow these costs in the coming years. If done successfully, this should lead to an increase in both operating expense margins and free cash flow.
If Alphabet's operating margins increase and more operating income turns into free cash flow, the company's consolidated free cash flow will grow much faster than revenues over the next five years.
Finally, Alphabet will use a significant portion of its cash flow and share buybacks. This will help increase free cash flow per share-the true measure of any stock's profitability-faster than free cash flow. Since 2019, the number of shares outstanding has declined by 6%. That pace should accelerate if Alphabet stock continues to trade at a cheap earnings multiple, which is a good thing for long-term investors.
That trio of revenue growth, margin expansion, and share repurchases gives Alphabet stock the potential to double over the next five years at a current EV/EBIT of 15.7x.
As long as the price is below 109.00, follow the recommendations below:
- Time frame: D1
- Recommendation: short position
- Entry point: 105.35
- Take Profit 1: 104.00
- Take Profit 2: 101.00
Alternative scenario:
If the level of 109.00 is broken-out, follow the recommendations below:
- Time frame: D1
- Recommendation: long position
- Entry point: 109.00
- Take Profit 1: 111.00
- Take Profit 2: 114.00
