Here is a deep dive on my understanding of Alphabet’s various operating segments, fundamentals, performance, returns followed by a valuation of the company based on the DCF model.
Alphabet has many businesses — the largest of which, of course, is Google. Google’s core products and platforms including Android, Chrome, Gmail, Google Maps, Google Play, Search, and YouTube each have over one billion monthly active users.
Operating segments
- Google Services – Revenue generated from advertising (“Google advertising”) as well as from other sources (“Google other revenues”).
- Google advertising revenues are comprised of Google Search, YouTube ads, Google Network (includes revenues generated on Network properties participating in AdMob, AdSense, and Google Ad Manager).
- Google advertising generates 80% of revenue.
- Google other revenues are comprised of Google Play, Devices and Services and YouTube non-advertising (YouTube Premium and YouTube TV subscriptions).
- This generates ~10% of revenue
- Google services has around 32% operating margin. In the year 2021, due to the pandemic induced economic growth, the operating margin rose to 38% however margins before pandemic is a more realistic expectation.
- Major revenue is lost towards “Cost of revenue” which is 46% of revenue. This includes:
- Percentage of the advertising revenues (“TAC rate”) for Google search which gets paid to distribution partners, and
- Content acquisition costs primarily for YouTube
- Data centers.
- Google advertising revenues are comprised of Google Search, YouTube ads, Google Network (includes revenues generated on Network properties participating in AdMob, AdSense, and Google Ad Manager).
- Google Cloud – Google Cloud includes Google Cloud Platform, Google Workspace, and other enterprise services.
- Generates ~7% of revenue.
- Has operating loss of ~15% and has been decreasing year-over-year.
- Other Bets: Other Bets is a combination of multiple operating segments that are not individually material. Revenues from Other Bets are generated primarily from the sale of health technology and internet services.
Competition
Alphabet faces competition from several domains:
- Search engines – Baidu, Microsoft’s Bing.
- Vertical search engines and e-commerce websites – Amazon and eBay (e-commerce), Kayak (travel queries), LinkedIn (job queries), and WebMD (health queries).
- Social networks – Facebook, Snap, and Twitter.
- Enterprise cloud services – Alibaba, Amazon, and Microsoft.
- Digital assistant providers – Amazon, Apple, and Microsoft.
Growth Outlook
Google search is probably reaching it’s limit in terms of revenue growth. Growth here is attributed to the inherent user growth and mobile phone usage. Much of Alphabet’s growth can be accounted to YouTube ads and Google cloud.
Consolidated segment results
| year over year change | 2021 | 2020 | 2019 | 2018 | 2017 |
| Revenue growth | 41% | 13% | 18% | 23% | 23% |
| Revenue constant currency | 39% | 14% | 20% | 22% | 24% |
| Paid clicks | 23% | 19% | 23% | 62% | 46% |
| Cost per click | 15% | (10)% | (6)% | (25)% | (19)% |
| TAC rate | 21.8% | 22.3% | 22.3% | 22.9% | 23% |
Paid clicks includes clicks on advertisements by end-users on Google search properties and other owned and operated properties including Gmail, Google Maps, and Google Play. Does not include YouTube ads as it has expanded to multiple formats.
Cost-per-click click- Driven revenues divided by the total number of paid clicks and that represents the average amount Google charges the advertisers for each engagement by the users.
Annual Highlights
2021
- All segments and sub-segments grew at 40-50% due to post pandemic effects.
- The increase in revenues was driven by all segments and sub-segments in Google Services and Google Cloud. The adverse effect of COVID-19 on 2020 advertising revenues also contributed to the higher year-over-year growth.
- Share repurchases were $50.3 billion.
2020
- Google started reporting segment results as Google Services, Google Cloud, and Other Bets
- Total revenue increase driven by an increase in both Google Services segment revenues and Google Cloud segment.
- Google Services segment revenue increased by $16.8 billion (11% increase)
- Google Cloud segment revenue increased by $4.1 billion (46% increase)
- Total cost of revenue increased by 18%, primarily driven by increase in cost for data centers and content acquisition costs for YouTube.
- Google cloud and YouTube ads are the fastest growing segments. YouTube ads growing at 30% and Google cloud growing at 45%.
- The revenue growth was partially offset by decrease in ad spending in first half of the year. This mainly impacted Google search revenue.
- Paid clicks not really increasing as much as before, indicating that google search is probably reaching it’s limit in terms of revenue growth. This growth is only coming from natural user growth and mobile phone usage.
- Acquired Fitbit, a leading wearables brand, for $2.1 billion.
- Repurchased shares of Alphabet Class C capital stock for an aggregate amount of $31.1 billion
2019
- High growth from YouTube ads and Google cloud.
- YouTube ads is growing at ~40% and contributes 10% to the total revenue.
- Google cloud is growing at >50% and contributes 5% to the total revenue.
- Increased in number of paid clicks primarily due to growth in views of YouTube engagement ads.
- Decrease in cost-per-click was also driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on other advertising platform.
- EU fine of $1.7 billion
- In November 2019, Alphabet entered into an agreement to acquire Fitbit, a leading wearables brand, for $7.35 per share, representing a total purchase price of approximately $2.1 billion
2018
- The EC decision imposed a €4.3 billion ($5.1 billion as of June 30, 2018) fine
2017
- Revenue growth primarily driven by increases in mobile search resulting from ongoing growth in user adoption and usage, as well as continued growth in advertiser activity.
- Also seeing growth in YouTube driven primarily by video advertising, Google Cloud offerings, hardware sales, and Google Play
- Very high tax rate of 53% due to the Tax Act that was enacted in December 2017. Alphabet recorded a tax liability for the one-time transition tax on accumulated foreign subsidiary earnings of $10.2 billion.
- The decrease in cost-per-click was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms.
- In June 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a €2.42 billion (approximately $2.74 billion as of June 27, 2017) fine.
- Repurchased Alphabet Class C capital stock for an aggregate amount of $4.8 billion.
Fundamentals
Working Capital Position
| Value | Median | Industry Median | Notes | |
| Current ratio | 2.93 | 5.14 | 2.60 | Current ratio decreased due to investment in PPE and operating leave. Further reduced because increase in current liabilities by $10 billion due to EU fines. |
| Cash ratio | 2.17 | 2.16 | 1.58 | – |
| Cash-to-Debt | 4.92 | 17.2 | 7.24 | Alphabet did not have any debt until recently. Due to low interest rates Alphabet issued new debt in recent years. However, the debt is insignificant as compared available cash and cash flow from operations. |
| Debt-to-Equity | 0.11 | 0.06 | 0.14 | Alphabet have very low debt. |
| Interest coverage | 227 | 209 | 62 | Alphabet earns more than enough to pay interest on it’s debts |
Alphabet is financially very strong.
Management
| 2017 | 2018 | 2019 | 2020 | 2021 | |
| Operating margin | 23.4% | 20.1% | 21.1% | 22.6% | 30.55% |
I’ll admit, I was a little surprised after seeing Alphabet’s operating margin. Low operating margin is because a significant portion of their revenue, ~40% goes towards TAC rates and content acquisition. The silver lining is that almost all of operating income is translated to net income because non-operating income (income from equity investments in the case of Alphabet) compensates more or less for the taxes on operating income. This has been happening for the past 4 years. Please note that non-operating assets ( income from investments and marketable security) will not be considered for valuation purposes.
Operating margin reached to 30% in 2021 due to the post pandemic boom but that does not seem to be a sustainable margin.
Returns
| 2017 | 2018 | 2019 | 2020 | 2021 | |
| RoE Return on Equity | 8.69% | 18.62% | 18.12% | 19% | 32% |
| RoIC Return on Invested Capital | 17.79% | 29.38% | 24.15% | 21.89% | 35.53% |
| RoA Return on Asset | 6.94% | 14.29% | 13.50% | 13.52% | 22.40% |
Returns were lower in 2017 due to a tax liability for the one-time transition tax on accumulated foreign subsidiary earnings of $10.2 billion i.e. around 50% of operating income were paid in taxes as part of one-time transition tax.
RoIC was abnormally high in 2018 due to $5.5 billion gain from equity security (which is ~6% of revenue, usually this is ~3%).
RoA for Alphabet is much lower than RoE & RoIC as RoA calculation uses total assets which includes large cash and marketable securities (totaling $140 billion) which is a non-operating asset. Current RoA without cash is 40% for 2021 and 25% for 2020.
Income analysis
Here we are trying to measure the reliability of earning using quality of income*. This value should be greater than 1 which indicates that earnings are not manipulated, is free of one-time adjustments to net income, and earnings are actually generated from sales and not other sources.
| 2017 | 2018 | 2019 | 2020 | 2021 |
| 2.93 | 1.56 | 1.58 | 1.61 | 1.20 |
Valuation
I have valued Alphabet based on discounted cash flow (DCF) model which discounts free cash flow available to equity holders after all debt and non-equity claims are paid. The discount rate used for this analysis is 9% which is the historic rate of return for S&P500.
Based on my DCF model, fair value for equity at Alphabet comes to $1.23 Trillion which is $1866 per share. Assuming 5% error, as per my analysis the fair value range should be $1772 – $1959 per share.
Please note that my valuation only considers operating items and ignores non-operating items like income/(loss) from sales of equity or marketable securities.
Disclaimer
The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.