In the wake of rival Snap's (SNAP 0.24%) preannouncing a deterioration in its results on Monday night, Google parent Alphabet (GOOG -0.34%) (GOOGL -0.27%) sold off hard in sympathy, down more than 5% the next day. And remember, this is on top of an already-bad year for tech stocks. Year to date, Alphabet is down nearly 27%, based on fears of a cyclical slowdown in advertising dollars.
But as Warren Buffett once said, "you pay a high price for a cheery consensus." With pessimism now being extrapolated across the digital advertising space, Alphabet looks quite cheap indeed -- even cheaper than its headline earnings would suggest.
Alphabet has a historically low P/E ratio
Of note, Alphabet's price-to-earnings ratio, based on trailing-12-month earnings, has fallen all the way to 19.4. That's a level not seen since the financial crisis of 2008-2009 and its subsequent European aftershocks in 2011-2012:
That would suggest that Alphabet shares are rather cheap. Skeptics might say it's possible the P/E should contract a bit over time as Alphabet gets larger, due to the law of large numbers. (As a company expands, its future growth declines.)
However, I think it's fair to say search advertising and Alphabet's other digital ad ecosystems have outperformed what investors thought possible 10 years ago. After all, despite its massive size, Google Search still grew 24.2% last quarter on top of difficult comparisons. Investors also pay higher multiples for stable, proven businesses, and Alphabet has certainly proved itself as one. So I don't buy that its multiple should contract naturally from here.
Today, Alphabet is even cheaper than the headline numbers suggest
Of course, when you buy Alphabet, you're now getting a more diversified company than 10 years ago. Notably, as digital ad profits have rolled in, Alphabet has invested heavily in new businesses, most notably Google Cloud, as well as "other bets," such as Waymo self-driving cars and other "moonshot" projects.
In 2021, Google Cloud had an operating loss of $3.1 billion -- a significant amount, albeit a big improvement from the $5.6 billion loss in the prior year. Meanwhile, "other bets" had an even bigger $5.3 billion operating loss, up from a $4.5 billion loss in the prior year. If those costs were added back, operating income would have actually been about 10.6% higher than the reported $78.7 billion figure.
But should you add those costs back? I would say mostly yes. Although Google Cloud is losing money, Amazon Web Services, the first-mover in the industry, made a 35% operating margin last quarter at a much larger scale. So at least for cloud, I think there are profits in the future and significant value.
The "other bets" segment is tougher to figure. As of now, it appears no one is assigning that much value to these projects; however, the people running Alphabet are no dummies, so I think there is at least some value there. Whether that value justifies its current billions of dollars in spending is another issue.
Excluding these items, Alphabet's 2021 operating income would have been $87.1 billion, even including all headquarter costs. Alphabet also made $12 billion in "other income," which incorporates gains on equity investments, interest income, and foreign currency gains. While that's not guaranteed to be positive every year, Alphabet has made positive "other income" each of the past three years.
Still, taking only the "core" Google services earnings and applying the 16.2% tax rate that Alphabet paid each of the last two years, 2021 net income for core Google services alone would have been around $73 billion.
At this writing, Alphabet has a market cap of around $1.43 trillion, about 19.5 times that figure. However, if you account for the $120 billion in extra net cash sitting on the balance sheet, Alphabet trades at a ratio of enterprise value (EV) to core Google earnings of just 17.9. By comparison, on a trailing 12-month basis, the S&P 500 trades at an EV-to-earnings ratio of 20.3.
Is Alphabet a better-than-average business?
Investors seem to be in a panic about the near-term prospects of an advertising slowdown. However, Google only posted a decline in revenue once, in the second quarter of 2020, just as the COVID-19 pandemic was beginning to spread worldwide. By the next quarter, revenue growth had already bounced back to a growth rate in the mid-teens. Even back in the 2008-2009 recession, Google still grew revenue, albeit more slowly than in prior years.
I think it's safe to say Alphabet's core business is still a growth business, and much better than the average stock in the S&P 500. Meanwhile, investors are getting that business at a 10% discount to the average stock, plus Google's cloud division, "other bets," other income and investments, and the huge cash pile...for free.
Will that cash ever make its way to shareholders, though? I would also say yes. While Alphabet has historically hoarded cash, in recent years it's started to return more cash to shareholders via share repurchases. The company just authorized another $70 billion in repurchases last quarter. Over time, it wouldn't surprise me to see management take the approach of Apple (AAPL 0.14%), which has kept lots of liquidity, but used debt against its cash holdings to buy back huge amounts of its own stock. Apple management has said that over the long term, it expects to reach a "net cash neutral" posture, meaning its debt will be equal to its cash. I don't see why Alphabet couldn't do the same, given the stability and profitability of its dominant digital-ad business.
Alphabet isn't Snap
Remember, while Snap also sells ads, its social media platform is nowhere near the same quality as Alphabet's search and other digital ads businesses. In fact, Snap is still generating massive losses on its bottom line, and has virtually no chance to make positive earnings for years.
Meanwhile, Alphabet trades at just over 19.5 times its core ad business earnings, but is actually much cheaper when factoring out its cash and other income. This is despite that business still showing a strong growth profile. And the loss-making cloud and "other bets" divisions are assigned either zero or negative value, despite there being a very good chance they contain significant positive value -- especially cloud. All in all, Alphabet looks like one of the cheapest stocks around, especially when considering the high quality of its franchises. Thanks, Snap.