Reading the data points of Alphabet’s earnings report a few days ago was like reading through a summary of Rogers Hornsby’s 1922 Triple Crown season with the St. Louis Cardinals when he led the National League with a .401 batting average, hit 42 home runs, clocked 152 RBIs, and led the league in doubles, runs scored, and on-base percentage to boot. Alphabet, the parent company of Google, turned in an earnings report of similar quality, headlined by revenue growth of 22%.
There seems to be minimal dissent that Alphabet is one of the dominant businesses in the world today. It has 24.5% earnings per share growth over the past decade. It’s the verb we use when looking up information online. It is so powerful Europe fines the company for this, that, or the other on a regular basis. It is sitting on over $100 billion in cash, enabling it to buy a seat at the table of all conceivable future tech business activities. The net profit margin of 24.4% is on par with that of Coca-Cola’s 26%.
The only business-related criticism of the core Google business model that is both meaningful and substantial relates to the rates that Google is able to capture on advertising income. The essential business model of Google is that it connects advertisers with online publishers and gets to keep $0.32 on every $1 that advertisers dedicate to online advertising through the Adsense program.
During recessions, advertising cut back on their spending. In 2008-2009, the price per ad decreased by 32%. During the previous recession, Google was expanding its number of advertisers and scope of audience by a greater clip than the amount of the ad price decline so the effect was not felt (in fact, Google’s earnings grew by 11% during the previous recession). That is unlikely to be the case today, as the online ad market has matured considerably.
I believe this business-related concern is adequately addressed by two present factors: (1) the $100 billion cash stash, which gives Alphabet tremendous power to not only weather storms but gobble up assets on the cheap in such a recession-driven scenario; and (2) even if advertising rates dropped by a wide amount, Google would still be profitable–it would take a nearly 70% drop in the price of ads for Google to run its ad business at cost.
The other concern relates to valuation. When Alphabet trades in the vicinity of $1,000 per share, with projected $37 to $40 per share in 2018 profits, the natural question is whether 25x earnings is too high price to continue holding the stock.
My answer to that question is no, for the same reason stated by Phil Fisher on page 135 of his commendable work “Common Stocks and Uncommon Profits”:
Before reaching hasty conclusions, let us look a little bit below the surface. Just what is overpriced? What are we trying to accomplish? Any really good stock will sell and should sell at a higher ratio to current earnings than a stock with a stable rather than expanding earning power. After all, the probability of participating in continued growth is clearly worth something…if a job has been correctly done when a common stock is purchased, the time to sell it is–almost never.”
The financial crisis was a decade ago. If someone bought Alphabet at its highest possible price for the plunge, the stock price to date has still tripled in value. Aside from the absolute peak, other moments before the financial crisis saw the stock trade in the $200 range for a valuation of 40x earnings. Investors to date still would have reaped a 5x return on investment.
Once a business in the midst of growing at a 20% annual clip is in your portfolio, the time to sell it should be never, unless the opportunity cost of the overvaluation punches you in the face–i.e. If Alphabet traded at $2,000 per share within the next year and you could simultaneously locate an equally applicable substitute. Even under these scenarios, an investor may be wise to hold.
Should you buy the stock today? Well, the right time to buy it was in June of 2016 (see Alphabet Stock: High Chance of Outperforming the S&P 500). The stock has returned 24% annualized since then. My view is that current shareholders should hold and not sell the stock, and I have no conviction as to whether it should be the subject of new purchases at this price.