Alphabet (GOOG 5.34%) (GOOGL 5.32%) is one of the world's most dominant companies. Its two largest divisions, the Google search engine and YouTube, have a market share of 86% and 76% in their respective industries. As a result, advertisers flock to these platforms because they know Google and YouTube will provide a fantastic return on ad dollars spent.
These divisions also provide Alphabet with massive cash flows for an initiative that benefits shareholders: stock buybacks. By repurchasing shares, Alphabet makes each remaining share more valuable as it now accounts for a larger piece of the overall company. Over time, this can provide huge returns for shareholders that hold on to the stock.
The positive effect of stock buybacks
When done correctly, stock buybacks can significantly boost shareholder returns. When a company owns a larger slice of its own business, each share gains value. A stock's valuation -- whether it's assessed from a price-to-earnings, price-to-free cash flow, or price-to-sales standpoint -- isn't affected by buybacks. Therefore, fewer shares translate to greater earnings per share and therefore a higher stock price for a given valuation.
However, if companies repurchase their stock at elevated valuations, it's a waste of capital. As demonstrated in the chart below, Alphabet has been reducing the number of shares outstanding since 2019.
But has Alphabet's management done a good job of repurchasing shares at a decent valuation? The chart below shows there hasn't been a particularly great time to repurchase shares until right now. Sitting at a record low price-to-free cash-flow valuation, Alphabet's stock is now cheaper than it has been during the past three and a half years.
In its earnings report for the first quarter of 2022, management announced a $70 billion repurchase plan to take advantage of this low valuation. That amount is enough to repurchase about 4.5% of Alphabet's current shares outstanding, which would bring the number of shares outstanding much closer to the 2019 levels seen in the first chart included here.
However, Alphabet uses shares as compensation for some of its employees. This bill totaled $4.5 billion last quarter, so if the repurchase plan is completed over the next year, the actual amount of shares truly retired will be around $52 billion. Still, this is a sizable repurchase amount. Can Alphabet afford to do it?
Strong cash flows allow Alphabet to repurchase what it wants
As of late March, Alphabet had more than $133 billion in cash and marketable securities on its balance sheet and less than $15 billion in long-term debt. With this much capital on hand, Alphabet could complete its repurchase plan, pay off its debts, and still have $48 billion on the balance sheet.
However, Alphabet continuously produces cash as a business. Last quarter, it generated $15.3 billion in free cash flow, enough to replenish its coffers after the buybacks in just five quarters. At that time, management will likely seek another repurchase authorization and continue reducing the shares outstanding. This interaction creates a flywheel effect and drives long-term capital appreciation for investors.
Alphabet is already a solid business. In the first quarter, it grew revenue 23% year over year and maintained a 30% operating margin. Although its Google Cloud division is in third place in market share, it operates in a fast-growing niche and is far from saturating the market. This segment grew sales 44% year over year and will likely become Alphabet's second-largest division (behind Google search), within the next few years.
Alphabet stock is at a low value, with solid growth potential, and management is devoting its cash flows to repurchasing stock. These two factors make the company one of the best long-term investments today. Take advantage of the current market sale to establish a position in one of the world's strongest companies.