This article first appeared on Simply Wall St News
Key Takeaways from This Analysis:
By most measures Alphabet appears to be attractively priced.
The deceleration of revenue growth has resulted in a very sharp drop in growth of operating income.
The market seems to be anticipating a substantial dip in earnings over the next few quarters.
Alphabet ( NASDAQ: GOOGL ) is a high-quality company with significant competitive advantages, a very strong balance sheet, and diverse revenue streams. It’s also trading on a price multiple that is low relative to its peers and to its own trading history. The valuation suggests the market is skeptical that growth is going to return anytime soon.
What is Alphabet worth?
When it comes to valuing a stock, there is no holy grail. Every approach to valuation has its pros and cons, and forward-looking valuations are based on assumptions that are educated guesses at best. What we can do is look at a range of valuation metrics to get an idea of what the market expects and what kind of performance might be priced into the current valuation.
Alphabet’s P/E ratio
Alphabet’s current price-to-earnings (P/E) ratio is just below 20. It hasn’t been this low since 2012, and for most of the last decade, it’s been above 30. P/E ratios are somewhat limited as valuation tools, but they do give us an idea of how optimistic investors are about a company’s future earnings growth.
A P/E of 19.5x implies that investors are currently the least optimistic they have been about Alphabet than they have been in the last decade. In fact, investors are less optimistic about the company than they are about the overall US market which trades on a P/E of 23.2x.
P/E ratio vs peers
We can also compare a company’s current P/E ratio to its peers, and to its industry. The image above reflects the fact that Alphabet’s P/E appears less optimistic than Apple ( NASDAQ: AAPL ), Microsoft ( NASDAQ: MSFT) , and Amazon ( NASDAQ: AMZN ). Meta’s ( NASDAQ: META ) P/E is lower at 12.7x, which isn’t surprising given the pressure the company is under.
P/E vs Fair P/E
The Simply Wall St fair P/E for Alphabet is a lot higher at 38.7x. The fair P/E is a new feature on the Simply Wall St stock reports which approximates the expected P/E ratio by accounting for earnings growth forecasts, profit margins, and risk factors.
Based on the last 12 months of earnings, the stock would need to trade at about $211 for the P/E ratio to reach 38.7x.
Fair Value Estimate
Finally, we can estimate the fair value using the discounted cash flow model . This model estimates the value of a stock by adding up the present value of the future cash flows that analysts have for the stock. The model is very sensitive to changes in the forecasts as well as the discount rate you use, so it really is just an estimate based on a set of assumptions.
Our current estimate based on these inputs is $251, which implies the stock price is undervalued by 57%. This estimate is also based on fairly conservative EPS growth rates compared to the last five years. You can learn more about estimating the value of Alphabet with your own inputs here .
The current average 12-month analyst price target is lower at $143, but price targets typically take market sentiment and other factors into account. This suggests that analysts do expect the stock price to take a while to reach its ‘fair value’.
How do current growth forecasts relate to the valuation
Alphabet is a company with several wide moats, diverse revenue streams, and a very strong balance sheet. The above valuation metrics suggest the stock is either very attractively valued or that the market is expecting a more protracted slowdown.
The table below reflects the relationship between revenue growth and growth in operating income i.e. operational leverage. As we can see, acceleration in revenue growth quickly translates into an even faster acceleration in the growth of operating income - however, the opposite is also true. In the last quarter, revenue growth slowed to 13% which left operating income flat from a year ago.
Analysts are already expecting Alphabet’s EPS to decline in the next two quarters. The current valuation may be suggesting investors expect this decline to be deeper, or last longer. Either way, two-quarters of declining earnings are likely to weigh on sentiment.
What this means for investors
If you are a long-term investor and believe Alphabet’s revenue growth can bounce back, the current price appears to be an opportunity. However, the current valuation also suggests that the market believes the next few quarters may weigh on the stock price. More bad news might already be reflected in the price - so it’s possible that the downside will be limited - but upside may also be limited until there is evidence that revenue growth is returning.
Take a look at our full analysis for Alphabet which includes some of the other factors and risks to consider.
Simply Wall St analyst Richard Bowman and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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