Stock valuations have come down across the board in 2022. With the U.S. market down around 15% and many individual stocks down much more, investors now get the opportunity to buy stakes in high-quality businesses at a discount. A perfect example of this is Alphabet (GOOG -3.68%) (GOOGL -3.89%), the parent company of Google, YouTube, and Google Cloud. The stock's enterprise value-to-EBIT (earnings before interest and taxes) is down to one of its lowest levels in the last 10 years, due to a 27% decline year to date (YTD) combined with continued earnings growth.
GOOG EV to EBIT data by YCharts
This discounted valuation in Alphabet provides an excellent opportunity for investors. Here's how the stock can double within the next five years from today's prices.
Steady top-line growth
Excluding time periods when COVID-19 disruptions affected the business, Alphabet has been able to steadily grow its revenue at around 20% for the last 10 years. The company is now doing $256.7 billion in annualized sales, making it one of the largest businesses in the world.
Even though the business is massive, I think Alphabet's revenue should continue compounding at 10%+ a year due for several reasons. First, Google Search and Alphabet's other advertising segments still have a lot of room to grow, especially internationally. With 2.8 billion Android smartphone users globally (Alphabet owns Android), Google has an easy path to retain its search engine market share as more and more people become regular internet users around the world. Google Search is Alphabet's most important segment, generating more than half of its revenue last quarter.
On top of search and other Google advertising products, Alphabet's YouTube and Google Cloud segments have tremendous promise for growth over the next five years. YouTube has an estimated 2.5 billion active users, making it one of the most used internet services globally. It is also extremely popular among younger people, with 95% of U.S. teens saying they use it on a regular basis. The app "only" generates $7.3 billion in quarterly revenue, or 10% of Alphabet's sales, but has plenty of potential for monetization with its enormous user base.
Google Cloud is one of the big three cloud infrastructure providers in the United States (along with Amazon Web Services and Microsoft Azure). The segment generated $6.3 billion in revenue last quarter and is growing 35.6% year over year. Third-party analysts expect the cloud computing market to grow around 15% annually for the next five years, if not longer. As long as Google Cloud retains or grows its market share, the segment should be a solid grower for Alphabet for years to come.
Margin expansion
Steady double-digit revenue growth is great, but in order for the stock to double within five years, Alphabet is going to need its profitability and free cash flow to grow at an even faster rate. Luckily, it has a few easy ways it can obtain operating leverage and expand its margins over the next few years.
Currently, Alphabet's operating margin is just under 30% and its free cash flow margin is 23.4%. These are impressive numbers, but look even better when you realize how much the company has reinvested for growth. Google Cloud had an operating loss of close to $1 billion just last quarter and is very capital intensive (you have to build a bunch of data centers before customers start paying for services). The Other Bets division is burning over $1.5 billion a quarter while generating minimal sales. Alphabet also has 174,000 employees, having added around 30,000 new workers in the last 12 months.
Management stated it will rein in or slow down these expenses in the coming years. If done successfully, this should lead to both operating and free cash flow margin expansion.
If Alphabet's operating margin expands and more of its operating income turns into free cash flow, the company's consolidated free cash flow should grow much faster than its revenue over the next five years.
Share repurchases
Lastly, Alphabet is taking a lot of its cash and repurchasing shares. This will help grow free cash flow per share -- the true measure of profitability for any stock -- faster than free cash flow. Shares outstanding have come down by 6% since 2019. This pace should accelerate if Alphabet's stock continues to trade at a cheap earnings multiple, which is a good thing for long-term investors.
This trifecta of revenue growth, margin expansion, and share repurchases gives Alphabet stock the potential to double over the next five years at its current EV/EBIT of 15.7x.
