By Ee Hsin Kok. Edited by Aniket Bose and Swastik Patel
Google is the search engine of the world and needs very little introduction. There’s an extremely good chance that if you are reading this article today, you use at least a few of Google’s services. While the company just started out as a search engine, over the years it has built up an ecosystem around Search with other successful offerings such as Youtube, Google Maps, Google Chrome, Gmail, Android, and many more. It is important to note that Google is owned by its parent company – Alphabet – which owns Google and all its subsidiaries. Alphabet is traded under the ticker symbol GOOGL (for class A shares with voting rights), and GOOG (for class C shares with no voting rights).
Below is a table from Alphabet’s 2021 Annual Report showing the company’s revenue from each segment
Source: Alphabet 2021 10K
From here, there are a few notable highlights:
- Advertising makes up 81% of total revenue:
- Alphabet is still primarily an advertising company. In fact, it is the number one online advertising company in the world.
- Google Search alone makes up over 57% of total revenue
- Youtube makes up 11.1% of total revenue
- Google Network makes up 12.3% of total revenue. This segment comprises revenues from AdMob, AdSense, and Google Ad Manager. These services act as a middleman and enable websites, apps, videos, and games to monetize themselves with ads.
- Google Other makes up 10.8% of revenue, this is revenue from the Google Play Store, YoutubeTV and Youtube Premium, as well as Google Pixel, FitBit, and Google Nest sales.
- Google Cloud makes up 7.4% of total revenue.
- This has been one of Google’s fastest growing segments and arguably one of the most important ones for the future given the secular trends behind the cloud business.
- Cloud was just 3.7% of total revenues in 2017 with 4.05 Billion in revenue. By the end of 2021 it was 7.4% of total revenues with over 19 Billion in Revenue. Google Cloud has grown at a compounded annual growth rate (CAGR) of 47% over the last 4 years, and will likely make up a bigger chunk of total revenues in the future.
Operating Income Makeup
The table below (from the same 2021 Annual report), shows Alphabet’s operating income from each segment.
Alphabet’s operating income is entirely based on their Google Services business (this includes their advertising and Google Other business). On the other hand, Google Cloud lost $3.1 Billion in 2021, and Other Bets lost $5.28 Billion. These two money losing segments are still in their infancy stages, and should ideally become profitable over time.
This means that Google Services has an operating margin (operating income / revenue) of 38.6%, Google Cloud has an operating margin of -16%, and Other Bets has an operating margin of -700%.
Google Services is the company’s current cash cow and only profitable segment. This segment comprises the advertising businesses: Search, Youtube, the Google Network business; as well as the hardware business: Pixel, Nest and Fitbit. A larger breakdown of Google’s services can be found here: https://finatic.org/2022/09/27/google-services/
This is the least liked of Alphabet’s segment, and for good reason. Other bets had revenues of $753 million in 2021, and yet lost $5.28 Billion. That is an operating margin of -700%. Based on the numbers alone it seems that it would be best if this segment was shut down altogether. However, Alphabet’s management is unlikely to do that as they believe in its big potential.
Other Bets is sort of like a Venture Capital fund. In the 2021 annual report it is described as “earlier stage technologies that are further afield from our core Google business”. Management also says “Alphabet’s investment in the portfolio of Other Bets includes emerging businesses at various stages of development, ranging from those in the R&D phase to those that are in the beginning stages of commercialization, and our goal is for them to become thriving, successful businesses in the medium to long term”.
Basically, most companies that they’ve invested in are yet to reach the commercialization stage, which explains why losses are so high and revenues so low. The two most notable businesses in this segment are Waymo and Verily. The former is focused on autonomous driving technologies while the latter focuses on the Life Sciences industry. To be frank, it is difficult to predict whether these bets will ever pay off for Alphabet. For the time being, their losses are a small hit to the bottom line, but if Alphabet’s main business begins to stall in revenue, hopefully management begins to reduce the losses from this segment.
There are three major risks for Alphabet: Advertising cyclicality, regulation, and competition.
Advertising spend has always been cyclical. When there are downturns in the economy, companies are forced to cut their advertising budgets. In the past, Alphabet has been able to mask the ablation of advertising through its growth into new markets. However, now that Alphabet’s advertising businesses have reached almost all of its total addressable market, growth is likely to start declining. Considering that the majority of Alphabet’s income comes from advertising, the company’s income may start becoming more cyclical than before.
Regulation. We have alluded to this in the article with mentions of the Google Play Store lawsuit, but regulation on big tech companies like Alphabet has and will continue to be a hurdle for them. The good news is that the US government is limited in its power over companies (as opposed to certain other countries in the East). Alphabet has been hit with fines in the past but that’s all regulators have been able to do. Europe is a little more concerning as they tend to regulate more heavily but there was also a fear over governments forcing a breakup of Microsoft in the 2000s, and Microsoft got through that just fine.
Finally, the last risk, and arguably the biggest one, is competition. We have been operating under the assumption that Google Search is an unrivaled monopoly, yet they had to pay Apple $15 Billion in 2021 to remain the default search provider. The fact that Alphabet is the one paying Apple shows who truly has the leverage in that relationship. It is unlikely, but if Apple decided to end the deal, and set up their own search engine. It would hurt both companies temporarily, but Apple could take massive market share from Google. Apple has an obsessed fan base with extremely high retention rates. If Apple is able to create a search engine that is extremely similar to Google Search in terms of quality, they may be able to steal a big market share from Google long term. That being said, it would be destructive to both companies to end their current relationship and Apple enjoys the easy $15B in income it makes for little to no effort.
Is it a Good Company?
Now that the business model and risks of Alphabet have been explained, let’s take a look at the numbers to see if Alphabet is a good company.
Starting with margins, the company has an overall gross margin of 56.7%. Compared to the average S&P margin of 45% this is pretty decent. However, where Alphabet really shines is its operating margin, which is at 29.6% over the Trailing Twelve Months. This is compared to the S&P average of around 17%. Interestingly, Alphabet’s operating margin was higher in 2010 at 35%, but fell to as low as 18.6% in 2019.
These operating margins also do a great job of showing how management has been developing Alphabet over the years. They started with one main business – Search, which had extremely high margins and then expanded into lower-margin businesses like Youtube. Margins shrank at first, and uninformed shareholders may not have been pleased with that. No one likes it when margins contract for 10 years straight, and many argue that that means a business is losing its competitive edge to others. However, management knew what they were doing and eventually scaled those low margin businesses to the point where they could use operating leverage to restore their margins again.
From a return on capital perspective, Alphabet is fantastic as well. In the most recent quarter, capital employed (Total Assets – Current Liabilities) was $293.83 Billion. In the Trailing Twelve Months (TTM), Real Free Cash Flow (Operating Cash Flow – Stock Based Compensation – Depreciation (proxy for maintenance capex) was $63.5 billion. That means a Return on Capital Employed of 21.6%, which is pretty good and over the S&P average of 15-16%. If we exclude the hoarding of $172.3 Billion in cash on the balance sheet, capital employed shrinks to $121.53 billion. That means a Return on Capital Employed figure of 52%, which is insanely high.
From a debt perspective, we want to see a conservative balance sheet. Alphabet has $172.3 billion in cash and $26.4 billion in debt. This means they have a net cash position as opposed to a net debt position. The net cash position happens to be $145.9 billion, which is extraordinarily high. In fact, it is almost double their $75 Billion in TTM operating expenses. In other words, Alphabet has an extremely formidable balance sheet that could weather a rainy day, a storm, or even a tycoon.
Is Management Good?
This is essentially the same segment as the one above but requires more qualitative analysis. High returns on capital are a proxy for great management, and Alphabet has just that, but there are many valid criticisms of their management, as well.
- Other Bets have been losing billions of dollars every single year and there is no sign of that stopping.
- Alphabet is hoarding too much cash. While this means they’ve built a formidable balance sheet, some would argue this balance sheet is unnecessarily formidable. The company has basically no debt relative to its income, so it would seem that the company does not need a net cash balance. Especially not one with almost double the yearly operating expenses of the whole company. Many have argued it is time Alphabet began distributing this excess cash as a dividend rather than letting it sit on the balance sheet.
Other than these criticisms, Alphabet’s management has been very impressive. Their return on capital numbers are good even with all the cash they are hoarding. If they were to reduce their cash balance by doing an accelerated buyback program, or by distributing a dividend, those returns on capital would look even more phenomenal.
Additionally, management has made many important acquisitions in the past and have successfully grown Alphabet from a single service company into an entire ecosystem of businesses. Let’s not forget they recognized the potential of Youtube in 2006, acquired it for just $1.6 Billion, and grew it to be worth north of $250 Billion today. They have also managed to monetize their surrounding businesses in very creative ways, the monetization of Google Maps for instance by having businesses advertise across the map is pretty ingenious.
In terms of improvements for management, introducing a small dividend of around $1/share as well as doing an accelerated buyback program (especially at current depressed prices) seems like a good thing to start. This is similar to what Apple started doing a few years back, especially when their stock was undervalued and was trading with a multiple in the low teens. The dividend program should cost Alphabet $13 Billion a year, which relative to their Free Cash Flow figures which were in the mid 60 Billion dollar range, is a conservative payout ratio of about 20%. The accelerated buyback program at these prices is an even better use of Alphabet’s capital. It should be mentioned that management did buy back $15 Billion in the most recent quarter, the most in Alphabet’s history, but that number should be around $30 billion now that prices are depressed. $30 billion would have been $18 billion more than the Free Cash Flow for the most recent quarter of $12 Billion. However, given the size of the balance sheet, an $18 billion burn for buybacks could last more than 8 quarters! That’s how big Alphabet’s $145.9 billion net cash position is.
Unless management is able to identify better opportunities to deploy their cash, the best use of capital would be to start a dividend program and/or perform accelerated buybacks.
Google is a gigantic company with many different segments, so we can value it using a discounted cash flow (DCF) model, or with a sum of the parts valuation.
Discounted Cash Flow Valuation
Using a simple Discounted Cash Flow model, we start with a “Real FCF (Free Cash Flow)” number of $64 Billion in 2021. Real Free Cash Flow is basically owner’s earnings, which is the figure that Warren Buffet uses to value companies. This number was calculated by taking the $91.65 billion in operating cash flow generated by Alphabet, subtracting $15.3B in stock-based compensation, and another $12.4B in maintenance capex (using depreciation as a proxy for maintenance capex).
In this model, we assume a 12% growth in free cash flow for the next 5 years, followed by 6% growth. We then take the average terminal value of a terminal multiple of 20, and a perpetuity growth rate of 4%. Note that this model isn’t exactly accurate, as Alphabet may not grow for 2022 due to macroeconomic factors plaguing the world today such as high inflation and quantitative tightening. Therefore, it is a possibility cash flow may fall into 2023, then pick up and accelerate at 20% in 2024. The future is extremely tough to predict. However, 12% average cash flow growth followed by 6% thereafter seems reasonable for a company with a track record like Alphabet.
This returns an intrinsic value (what we think is a fair price for the company) of $1.67 trillion for the whole company, or $1.82 trillion after we add the cash and subtract the debt on the balance sheet.
Sum Of The Parts Valuation
Using a sum of the parts calculation, let’s go over each of Alphabet’s segments:
- Google Search, $149B in revenue in 2021. Operating margins of at least 35%, so $52B in operating income, grew at 20% growth since 2017. Expected growth is in the low teens for the next 5 years, and the business has a very strong moat, so we’ll assign a conservative PE of 20. That means the search business is worth $1.04 trillion.
- Youtube Ads, we previously valued this segment earlier in the article was $28.8B in revenue, around $10B in operating income. High teens growth for the future, and very strong moat as well, so we assign a PE of 25. The Youtube Ads segment is worth $250 billion.
- Google Network, the middleman between sites, games and apps are looking to monetize via ads. This segment was not discussed extensively in the article, but it’s been growing top line at 15.8% since 2017. Let’s assume 35% operating margins for this business (slightly below the average margins of 38.6% for the Google Services segment as a whole). On $31.7B in revenue, that’s an operating income of $11B. We assign it a PE of 16 due to lower growth relative to search and youtube. This segment is worth $176 billion.
- Google Other, this is the Play store, YoutubeTV, Youtube Premium, and hardware business.
- We previously assumed Google Play did $15.68B in revenue in 2021 and probably had an operating margin around 60%. That means $9.4B in operating income. Conservatively, growth will probably be around 10% for Play store, so we assign it a low P/E multiple of 14. That means the Play Store is worth $131 billion.
- Youtube TV and Youtube Premium are likely operating on negative margins. We’ll be conservative and value this business at $0 for now. Although it has tons of profit potential in the future.
- The hardware businesses of Google Nest, Google Pixel, and Fitbit are difficult to value, as we don’t know their margins and profitability. We do know that Google acquired Fitbit for $2.1 billion so it is at least worth that,Nest Labs was acquired for $3.2 billion in 2014, and that Google Pixel is gaining market share in the US. These businesses are definitely worth something, but we’ll assign them a value of $0 for now just to be conservative.
- Google Cloud, this is one of the most important segments for Google’s future. As explained above, Google Cloud has enormous potential in the future. This is an estimate but if Google Cloud continues to grow its revenues at a 30% rate till 2026, and 15% till 2030, it will eventually reach 20% operating margins in 2030. That would mean $24.4B in operating income on $122.4B of revenue. Let’s then give it a P/E of 20 given that there would still be future runway for growth and margin expansion even after that target is reached in 2030. That would mean it would be worth $488 billion in 2030. We then discount that back to 2021 with a 10% yearly discount rate, that gives us a present value of roughly $207 billion.
- Other Bets, this is a loss making speculative business. It may or may not work out into the future and it certainly is costing Alphabet $5 billion every year. That said, we’ll assume it’s not worth a negative amount as Alphabet clearly sees something there, but to be conservative we won’t give it a value either. It’s worth $0 as well.
Now let’s add all the parts up:
- Google Search ($1.02 trillion)
- Youtube Ads ($250 billion)
- Google Network ($176 billion)
- Google Other ($131 billion)
- Google Cloud ($488 billion)
- Other Bets ($0 billion)
That gives us a sum of the parts valuation of $2.065 trillion. When we add Cash ($172.3 billion) and subtract debt ($26.4 billion), that gets us to a value of $2.21 trillion.
The average of the sum of the parts valuation and the discounted cash flow model valuation is $1.67 trillion + $2.21 trillion / 2 = $1.94 trillion.
Today, we can buy Alphabet at a stock price of $102.80 which corresponds to an estimated $1.35 trillion in market cap. That means we can buy shares at a 31% discount to our estimated intrinsic value, which for a great company like Alphabet is like a fantastic deal.
Alphabet has turned itself from a search engine into one of the largest and most valuable companies in the world. The company operates in various different segments, and is currently still heavily reliant on advertising for its income, but is set to diversify its income streams into the future. The company has a strong economic moat, great margins, and good returns on capital. Alphabet may or may not be the best business in the world but it certainly is one of the best. Today, one can purchase the business at a good discount to estimated intrinsic value.