Looking at how companies perform through different economic cycles can lead to valuable insights. This is especially critical if a company is exposed to a cyclical industry.
Advertising can be considered cyclical, as it rises and falls with economic sentiment. This affects advertising-heavy companies like Alphabet (GOOG) (GOOGL), and it also clues us into what we can expect from Alphabet in the future.
Advertising revenue is starting to increase
Alphabet is highly exposed to advertising, as 76% of revenue comes from this source. This isn’t all bad, as advertising has been a great business for decades. Still, advertising budgets are the first thing that gets cut by a business when it sees troubling times ahead.
As a result, Alphabet’s revenue tends to fall whenever recession fears rise.
Slightly before recession probability peaks, Alphabet’s revenue growth takes a serious dip. This happened in 2009, 2013, 2014, 2020, and 2023. While these declines aren’t investors’ favorite, there is a silver lining if you’re patient: Revenue grows at an above-average pace following these dips.
Alphabet’s last quarter showed a continued acceleration in the advertising space, but more is on the horizon.
Chief business officer Philipp Schindler noted on Alphabet’s Q4 conference call how generative artificial intelligence (AI) is starting to improve ads, as advertisers are seeing about a 6% improvement in conversion dollars. This capability hasn’t been rolled out to every advertiser yet, so this continual improvement helps solidify Alphabet’s Google platform on top of the search engine world.
The combined trend of AI and economic outlook improvement should propel Alphabet’s earnings higher, making the stock appear cheaper than it already is.
Alphabet’s stock is cheap compared to other benchmarks
Because Alphabet is a mature business, I’ll use its price-to-earnings (P/E) ratio to value it. This uses the company’s trailing (or forward) 12 months of earnings, but using Alphabet’s trailing earnings isn’t smart because the business wasn’t optimized in profits in early 2023 due to overstaffing.
As a result, I’ll use Alphabet’s forward earnings (which uses analyst projections) compared to historical trailing earnings trends to assess the company’s valuation.
From this perspective, it’s fairly evident that Alphabet is trading below its average valuation. Additionally, its valuation is fairly close to the S&P 500‘s forward P/E of 20, meaning the market views Alphabet as an average company.
Alphabet has been a top performer for a long time, so this mediocre tag doesn’t make sense. Furthermore, Alphabet is drastically undervalued compared to other tech giants.
Alphabet is the third-largest U.S. company, although Amazon is getting closer to overtaking it. Both Microsoft and Apple are much larger ($3.08 trillion and $2.91 trillion, respectively) than Alphabet at $1.82 trillion.
However, these trade at 35 (Microsoft) and 29 (Apple) times forward earnings. Alphabet would trade 33% higher if it received Apple’s premium and 64% higher if it got Microsoft’s.
Although you can make the argument Microsoft deserves a higher premium than Alphabet due to its quicker growth (Alphabet grew revenue by 13.5% while Microsoft grew it by 17.6%), that argument falls apart when comparing it to Apple (which only grew revenue by 2% in the past quarter and had falling revenue the previous four quarters).
Alphabet is both a recovering business and an undervalued stock. The combination of these two things set the stage for a stock that could skyrocket, and with Alphabet’s track record, it should be slated to outperform many of its peers in the coming years.
— Keithen Drury
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Source: The Motley Fool