Shares in Google’s parent company Alphabet (NSADAQ:GOOG) trade at a (forward) price-to-earnings (P/E) ratio of 17. Based on the last five years, that’s unusually low.
The business is growing well and stock looks like a no-brainer. But I do have a brain, so I’ve been trying to use it to figure out why the market isn’t more positive on the stock.
Antitrust
The biggest and most obvious reason is probably antitrust. Alphabet’s been found guilty of maintaining an illegal monopoly and the question is what happens next?
One idea is that nothing much is going to happen, so the stock being down 8% this year is a buying opportunity. But I think this is a dangerous line of thought.
As I see it, things might turn out ok – and it’s definitely not all bad. Not paying Apple $20bn for the privilege of being the default iPhone search engine is probably a welcome development.
On the other hand, the company having to divest some of its operations could be a big problem. Even if this is unlikely, the magnitude of the risk means investors shouldn’t be complacent.
Cash generation
A less obvious concern is Alphabet’s status as a cash machine. The firm has a reputation for strong free cash flows with low capital expenditures, but things have changed recently.
In 2015, the company generated $16.5bn in free cash using just under $24bn in fixed assets – a 69% return. But over the last 12 months, this has fallen to around 41%. The reason is Alphabet’s been spending on artificial intelligence (AI), which might pay off in the future. If it does, the increased capital expenditures will be an investment, not a cost.
Investors should however, note the effect this is having on the firm’s cash flows in the short term. And this also weighs on the valuation picture with the stock at the moment.
Valuation
A market value of $2trn means $75bn in annual free cash translates to a return of 3.75% a year. But there’s something else investors need to consider in valuing Alphabet shares. The firm currently issues around $23bn a year in stock-based compensation. This is the value of the shares the company issues uses to pay its employees.
These aren’t a cash expense, so they don’t weigh on free cash flow. But Alphabet does have to buy them back to prevent its share count rising and diluting the value of its existing shares.
Factoring this in leaves around $52bn in annual free cash – a 2.6% return on a $2trn market-cap. The firm’s growth prospects might justify this, but I don’t think it makes the stock a no-brainer.
A buying opportunity?
Alphabet shares are trading at an unusually low P/E at the moment. And while this might make them look like an obvious opportunity, there’s a lot for investors to think carefully about.
There’s ongoing legal uncertainty, higher capital expenditures, and high stock-based compensation costs to consider. All of these are genuine issues to consider.
None of these automatically means the stock won’t be a good investment. But for anyone wondering why the stock looks cheap, I think there are clear reasons.
