Can you feel the artificial intelligence (AI) hype cycle hitting a fever pitch? I sure can.
It seems like all any news outlet or investor wants to discuss right now is AI. After OpenAI's lifelike query tool called ChatGPT gained popularity in late 2022 and early 2023, Microsoft decided to pour $10 billion into the start-up and integrate these tools across its Office and Bing search products. Executives like CEO Satya Nadella said it hoped to start increasing its competition with Alphabet's (GOOG 1.43%) Google Search services with these new products, potentially taking market share from the dominant search engine provider.
Alphabet investors initially responded to this news bearishly, selling off the stock by 10% to 20% in the weeks following Microsoft's product announcements. But after market share data came out in Google's favor and Alphabet started launching a plethora of AI tools that rivaled Microsoft/OpenAI, investors flipped from bearish to bullish. As of this writing, Alphabet stock is up an impressive 40% year to date (YTD), making the S&P 500's 9% returns look pale in comparison.
Is it too late to buy Alphabet stock? Or is there still an opportunity for investors to make money here?
AI fears melting away
After Microsoft made its big announcements around AI, there was a fear among investors that Google Search would start losing market share to Bing. So far, this narrative is all bark and no bite. In fact, in recent months, Bing's market share has actually gone down.
Of course, this new AI strategy from Microsoft is just beginning, but so far, it looks like it is going to take more than a shiny new AI tool to convince users to leave their beloved Google Search.
This is especially true when Google can seemingly copy all of your innovations. In recent months, Google slowly released its own lifelike chatbot called Google Bard, with the product now getting fully integrated into Google Search. There have also been major AI updates to the suite of Google Workspace tools like Google Drive and Gmail, which compete directly with Microsoft's Office product suite.
Going even further, Google is selling these new AI tools to third-party developers through its Google Cloud division.
For example, Google's AI biotechnology and molecular analysis tools are being sold to drug companies to help them get products to market faster. Apply this example to many other industries, and you can see that Alphabet's potential to make money with AI is much bigger than just search engines and workplace software.
What will growth look like?
As such a large business (revenue was $284 billion over the last 12 months), it will be virtually impossible for Alphabet to put up the same impressive revenue growth it has for the last two decades. But that doesn't mean the company still can't consistently grow its top line while also expanding margins, with these new AI tools potentially growing its addressable market as well.
For one, the company's Google Cloud division should continue to grow quickly, especially once you consider how computationally intensive modern AI services are. Google Cloud's revenue grew 28% year over year last quarter to $7.45 billion and now makes up 11% of Alphabet's consolidated revenue. Over the next five years, this should be a significant contributor to the company's top-line growth.
Google Search and other consumer services will likely grow much slower than the cloud division due to the law of large numbers. However, I still think that with the steady growth of internet usage, Google Search's dominant market position, and a widening competitive advantage due to these new AI tools like Google Bard, Alphabet's search/advertising division is still set up for success this decade.
Its valuation is getting up there
With the stock up 40%, Alphabet's valuation has gone from cheap to potentially expensive rather quickly. Earlier this year, shares traded at a trailing price-to-earnings ratio (P/E) of close to 16. Today, the stock's P/E ratio is 27.4, which is above the market average of 24.
Strong growth at Google Cloud, new revenue opportunities with these AI tools, and margin expansion should help Alphabet continue to grow its earnings power over the next decade. But with the business already so large, it will be tough for the stock to outperform if you buy at an earnings multiple above the market average. The math is difficult to justify once your revenue base gets into the hundreds of billions.
GOOG P/E Ratio data by YCharts.
If you already own Alphabet, there's no reason to sell your shares. But any prospective investor should be cautious with the stock currently trading at an expensive P/E ratio of close to 30. Perhaps it is best to keep Alphabet on the watchlist for now, or only take a small position if you really like the business.
