Over the past year or two, investors have seen a number of popular stocks carry out well-publicized stock splits. For instance, Amazon completed a 20-for-1 stock split on June 6, Shopify is planning a 10-for-1 stock split on June 28, and Alphabet's (GOOG 0.56%) (GOOGL 0.66%) 20-for-1 stock split is scheduled to occur on July 15.
Historically, stock splits have been a sign of management's confidence in the company's ability to keep growing and investors become bullish as well. A recent Bank of America study of companies that have split their stocks shows (on average) they significantly outperform the broader market in the 12 months following the split. But investing veterans know that stock splits don't change the value of a stock in any real intrinsic way. It just cuts up the same-sized pie into a different number of equal-sized pieces.
Using that BofA study as an indicator, short-term investors should be piling into Alphabet's stock, hoping for a quick return on investment. But long-term investors would be prudent to consider the fact that there are plenty of other, much more valid reasons to purchase Alphabet stock besides its upcoming 20-for-1 stock split.
Could advertising revenue be in danger?
Alphabet is the third-largest company by market cap in the U.S. (behind No. 1 Apple and No. 2 Microsoft). The parent company of dominant brands like Google and YouTube reached that large size with significant help from the billions in advertising revenue it generates each year.
Because it's so reliant on advertising revenue, Alphabet's stock can get volatile when ad revenue is threatened, like during a recession. Companies historically cut back on their advertising budgets during recessionary periods. With roughly 80% of Alphabet's revenue derived from ad sources, this represents a significant potential headwind.
What Alphabet has in its favor is that the company's platforms are some of the most desirable advertising spaces available today. If advertisers are going to cut back their budgets, the remaining funds are going to concentrate more in the most effective areas (like online search and short-form videos). The dominance of these platforms will likely make them the last place advertisers will cut their spending. Google and YouTube have a vast audience with easily interpreted ad data. Companies may lighten their ad spending, but targeted ads are still valuable.
The ad slowdown scare as it relates to Alphabet is overblown, and the market is overreacting.
Alphabet has strong financials
Even in a challenging first-quarter environment, Alphabet managed to grow its revenue by 23% year over year, while also managing a 30% operating margin. Free cash flow was $15.3 billion, even with nearly $10 billion in capital expenditures.
These metrics are underscored by Alphabet's impressive balance sheet with $134 billion in cash and marketable securities against a mere $14.8 billion in debt. Even if Alphabet's advertising revenue falls, the company is in strong enough financial shape to manage it until the next economic-growth period.
Looking at the stock's valuation, it's valued at price-to-earnings ratios not seen in roughly a decade.
GOOGL PE Ratio data by YCharts.
At a price-to-earnings ratio of 19.15, Alphabet is barely more expensive than the S&P 500 index at 18.5 times earnings. Compared to other tech giants, like Microsoft at 25.5 or Apple at 21.1 times earnings, Alphabet is genuinely a bargain at these prices.
Other catalysts
There are rational reasons why companies do stock splits that have nothing to do with boosting the stock price. For instance, the company can more easily use its stock to compensate employees through options and incentives. A lower per-share price can open up ownership options to investors that don't have access to fractional shares.
For long-term investors, the split represents a generational buying opportunity for Alphabet stock. Even if a recession occurs, advertising will come roaring back as the economy recovers. Additionally, Alphabet has an active $70 billion share-repurchase plan. With today's low prices, Alphabet's management is getting more bang for its buck for every share it repurchases. Lowering the share count is good for investors because earnings per share increases if there are fewer shares to account for in the calculation.
Purchasing Alphabet stock because of the stock split isn't the worst investment strategy, but there are better reasons to buy the stock. Alphabet is an industry leader built to weather even the toughest of recessions. Investors with at least a three- to five-year investing horizon should consider picking up shares of this stalwart today.
