Alphabet's(GOOG -1.10%) (GOOGL -1.23%) Google is one of the most dominant businesses in modern history.
The internet search engine claims more than 90% market share in much of the world, has grown rapidly throughout its history, and generates huge profit margins. In spite of the strength in Google and in Alphabet's other properties like YouTube, the stock is actually trading at a discount to the S&P 500.
Currently, Alphabet is valued at a price-to-earnings (P/E) ratio of 18, and if you back out its $140 billion in cash and marketable securities, its P/E ratio is only 16. By comparison, the S&P 500 trades at a P/E multiple of just under 21.
So why is Alphabet so cheap? After the stock plunged last year, let's take a look at the reasons why it's trading so low today.
Image source: Google.
What the bears think
It's no secret that Alphabet is struggling these days. Its third-quarter earnings report made that abundantly clear. Revenue growth slowed to just 6%, or 11% in constant currency, and the company's profits actually declined. Earnings per share fell from $1.40 to $1.06 as the company ramped up hiring over the past year.
Wall Street expects those headwinds to continue over the coming quarters, calling for earnings per share to decline in the fourth and first quarters, and sees revenue growth in just the low single digits in that period. Investors seem concerned about wasteful spending at the company as losses at "other bets" -- its start-up incubator that includes projects like autonomous vehicle subsidiary Waymo -- have ballooned to $1.6 billion as of the third quarter.
Additionally, Google Cloud continues to lose billions a year even as rivals like Microsoft Azure and Amazon Web Services are highly profitable. The company has promised to slow down its headcount growth, but investors have long questioned why Alphabet needs nearly 200,000 employees in the first place.
The deceleration in revenue growth has come as the broader digital ad market has slowed, with peers like Meta Platforms, Snap, and Roku all reporting sharp declines in revenue growth.
The advertising business is cyclical, so growth should improve once the economy bounces back. However, there are other challenges facing Alphabet's ad business. TikTok appears to be taking market share, primarily from social media, but also from YouTube and Google, and investors are concerned that the digital ad market is approaching maturity.
Digital ad spending made up more than 60% of ad spending in 2022, according to estimates from Zenith Media, meaning channels like Google have already taken most of the available market share from traditional media. While the digital ad market will continue to grow, its pace will likely be slower than it was in the past decade.
Finally, Google is facing a real threat from an increasingly popular chatbot called ChatGPT -- especially after its creator, OpenAI, formed a partnership with Microsoft. The move could take market share from Google Search, or force the company to undermine its business model by adding a similar chatbot feature or spending to incorporate artificial intelligence (AI) in other ways.
Is Alphabet stock a buy?
Some of the challenges facing Alphabet are concerning, but many of them are just cyclical. The company has experienced downturns in ad spending twice before, during the Great Recession and the pandemic, and both times it recovered rapidly when the economy improved.
Similarly, the company has promised to reel in headcount growth. On the Q3 earnings call, management said that it would cut headcount growth by more than half in the fourth quarter, and it expected the effect of the slowdown to become more noticeable this year.
In other words, the company will eventually return to bottom-line growth, and revenue growth should reaccelerate once the economy bounces back and business confidence starts to improve.
The threat from ChatGPT should be taken seriously, but it's too early at this point to know if it will have a fundamental effect on Alphabet, and the sell-off in the stock predates the launch of the new AI chatbot.
Given its track record of strong growth, Alphabet seems likely to outgrow the S&P 500 in a healthy economy. With the stock trading at a discount to the broad-market index, right now looks like a great buying opportunity for Alphabet stock.
