In the GARP world, there are very few investments as attractive as Alphabet Inc (NASDAQ:GOOG). Alphabet has reported multiple 20%-plus revenue growth quarters in a row (including +23% last quarter), but Google stock trades at just 25-times forward earnings.
If you’re not familiar, GARP stands for Growth At A Reasonable Price and is one of the more popular and reasonable stock-picking strategies out there. GARP investors don’t pick hyper-valued growth stocks or low-growth value stocks, but rather stocks that are somewhere in between.
To put Google Stock in the GARP perspective, the average revenue growth rate in market last quarter was 8.5%, while the S&P 500 is trading at 16-times forward earnings. Thus, the market’s forward earnings multiple is essentially double its revenue growth rate.
But Alphabet stock’s forward earnings multiple is almost the same as its revenue growth rate.
Sound like a GARP stock?
It is. Google stock is very cheap trading below $1,100. While margin pressures do keep the upside in this name from being astronomical, this is a stock which is presently undervalued and easily has room to run to $1,500 and higher over the next several years.
Here’s a deeper look:
The Big Growth At Google
Google is that company that never breaks below 20% revenue growth. For the past several quarters, Google’s revenue growth has remained resiliently north of 20% despite increasing scale and tough laps.
And there is a good reason for that.
The company’s core advertising business isn’t slowing at all. In fact, if anything, it looks like digital advertising is actually gaining momentum right now as cord-cutting accelerates and more and more dollars shift into the digital channel.
Core ad revenue growth at Google last quarter was 24%, better than the prior quarter’s 22% growth rate. A similar acceleration in ad revenue growth was also seen in fellow digital ad peers Facebook Inc (NASDAQ:FB) and Twitter Inc (NYSE:TWTR).
This momentum will continue. These digital ad behemoths have all the data in the world to create the most tailored and most effective advertising solutions on the planet. As such, ad dollars will continue to flow at a robust rate into Google.
Beyond this core advertising business, Google is also building out its capabilities in multiple other nascent, high-growth markets.
Waymo, the company’s self-driving unit, is the leader in the autonomous driving space and is on the verge of launching a self-driving, Uber-like service in Phoenix this year.
Google Cloud is a fast growing and major player in the hyper-growth cloud market. Google Home is behind a series of market-leading smart home products. The company also just launched Shopping Actions, which turns Google search into a digital commerce marketplace, and that thrusts the company into the secular growth e-commerce space.
In other words, there is ton going on at Google outside of the core ad business. The sum of all those other businesses might not be much right now. But in the future when the core ad business starts to cool off from saturation, these businesses should be adding billions of dollars to the top-line and will help keep growth rates big.
The Cheap Valuation on Google Stock
Despite these robust growth prospects, Alphabet stock continues to trade with a relatively weak multiple.
The reason for the discounted valuation is margin concerns. These concerns are very valid. The shift from desktop advertising to mobile advertising comes with a shift towards lower margins, so GOOGL’s core ad business is now running on lower margins (the whole story there is driven by mobile).
This shift won’t slow down any time soon, so margins in the core ad business are on watch.
Plus, Google is investing an arm and a leg into it’s nascent, hyper-growth businesses like Waymo. These investments are also weighing on margins.
The sum of these margin compression headwinds has resulted in operating margins falling to 22% last quarter, versus 27% in the year ago quarter. Some of these headwinds will stay (the mobile shift). Others will disappear with scale (the investments into Waymo).
Thus, margins should rebound in the long-term, but not to previous peak levels. Nonetheless, even if operating margins only rebound to 25% over the next five years and revenue growth remains in the 15-20% range, I think GOOGL can do about $80 in earnings per share in five years.
A market-average growth multiple of 20-times forward earnings on that implies a four-year forward price target of $1,600.
Discounted back by 10% per year, that equates to a year-end price target for Alphabet stock of roughly $1,200.
Bottom Line on GOOGL Stock
It’s an ideal GARP stock. Upside isn’t huge because of margin pressures, but downside is protected by a cheap valuation against the backdrop of big growth.
All together, Alphabet stock will continue to head higher over the next several quarters and years.
As of this writing, Luke Lango was long FB and GOOG.
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