Early in February, Alphabet (GOOG 0.29%) (GOOGL -0.23%) stock fell by 12% over a two-day span after Microsoft unveiled its new ChatGPT-powered version of the Bing search engine and Alphabet botched the introduction of Bard AI, its competitor to ChatGPT.

Since then, the conventional wisdom seems to be that Alphabet stock has become oversold due to an exaggerated threat from its big tech rival. However, the stock has drifted lower since then amid broader pressure on the tech sector.

According to most conventional metrics, Alphabet stock does look cheap. Its price-to-earnings ratio is roughly 19, and analysts expect solid growth from the company both this year and next, seeing earnings per share increasing to $5.09 in 2023, then jumping by 20% next year to $6.11. That means the stock is trading at a price-to-earnings multiple of 15 based on next year's expected earnings. The stock is even cheaper when you back out the $114 billion in cash and equivalents the company has on its balance sheet.

However, Alphabet stock is still up nearly 10% from its recent low last November, showing that shares were already cheap even before ChatGPT came on the scene. The reason has to do more with the future of its advertising business, and there are two significant challenges facing the company that have nothing to do with ChatGPT.

A man clicking on a search bar.

Image source: Getty Images.

A cyclical headwind

Alphabet's revenue growth has slowed significantly as advertising demand has slackened. The Google parent isn't the only ad platform experiencing these headwinds -- peers like Meta PlatformsRoku, and Snap have all reported weak revenue growth.

At Alphabet, revenue rose just 1% in the fourth quarter, or 7% in currency-neutral terms, and revenue from its advertising business fell 3.6%. Advertising is notoriously cyclical, but it's unclear when demand will bounce back as the Federal Reserve continues to raise benchmark interest rates, and some economists are predicting that a recession will hit in the second half of the year.

In other words, Alphabet's revenue growth could be sluggish for at least the rest of the year and into 2024, though analysts seem to think revenue growth will reaccelerate as soon as the second quarter of 2023. However, Wall Street has consistently overestimated the company's performance over the last year; Alphabet has missed earnings estimates in each of its last four quarters.

A maturing ad market

The longer-term challenge facing Alphabet is that the digital ad market is starting to mature. Digital ad spending now makes up the majority of advertising spending in the U.S., meaning the highest growth days when Alphabet was grabbing market share from legacy channels like television and print advertising are mostly over. Additionally, Alphabet will have to compete with newer digital channels like connected TV, which is seeing a boom as more and more media companies launch ad-supported streaming services.

Alphabet's advertising business is also likely to run into the law of large numbers soon. It brought in revenue of $224.5 billion last year, which alone would make it one of the biggest companies in the world. In order to grow that ad business by 20%, the company would have to find another $44 billion in revenue, which would be no small feat. While it is the biggest advertising business in the world, it's still competing for advertising dollars with a wide range of options.

As its revenue base gets larger and the digital ad market matures, Alphabet's growth rate should naturally slow down. 

What it means for investors

When you factor in the cyclical headwinds, which could last for at least another year, and the maturing ad market, Alphabet stock doesn't quite look like the bargain that some investors seem to think it is.

Meanwhile, the threat to its business from ChatGPT deserves to be taken into account. While it's too early to know how AI-driven search will play out, Microsoft CEO Satya Nadella's prediction that margins will come down in search seems logical based on the computing costs required.

Until Alphabet can convince the market that it isn't restrained by any of these challenges, the stock is likely to continue to trade at modest valuations.