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Alphabet Inc (GOOG) produced strong revenue and free cash flow results for Q2. However, GOOG stock is lower as the market did not like that its free cash flow (FCF) margins fell. Nevertheless, going forward, the stock still looks cheap based on analysts' sales forecasts and its FCF margin history.
GOOG is at $166.68 in morning trading on Friday, July 26. This is down 1.8% and it's off $25.78 from $192.66 on July 10, or -13.4% in the past 2 weeks.
Nevertheless, based on my calculations GOOG stock could still be worth over 13% more or $188 per share. This is based on analysts' revenue forecasts and its average FCF margins. This article will show how I derived this target price.
Strong Results, Albeit with Lower FCF Margins
On July 23, Alphabet posted 14% higher revenue (+15% on a constant currency basis) Y/Y for Q2 (i.e., $84.7 billion vs. $74.6 billion a year ago). This was similar to its Q1 results when sales rose 15% Y/Y (+16% constant currency).
Moreover, its operating income shot up by over 25.58% to $27.43 billion compared to $21.84 a year ago. In addition, its operating margins were high at 32% compared to 29% a year earlier. Last quarter its operating margins were 32% as well.
However, the market took note that free cash flow (FCF) fell Y/Y and its FCF margins were also lower. This is because Alphabet is spending much more (i.e., capex) on its AI investments. This is due to its huge investments in servers for its data centers, as explained during the Q2 earnings call.
For example, Alphabet's FCF came in at $13.454 billion, vs. $16.836 in Q1. This means that its FCF margin (i.e., FCF / revenue) fell from 20.9% in Q1 to 15.9% in Q2 (i.e., $13.454 b FCF/$84.742 sales).
The table above that I have prepared shows that Alphabet's capex investments have almost doubled in the past year from $6.888 in Q2 2023 to $13.186 billion in Q2 2024 (+91.4%). That effectively lowered its FCF and FCF margins.
Projecting FCF
Nevertheless, in the past year, Alphabet has still generated an average of 18.5% of sales in FCF. That can be seen by dividing $60.787 billion in trailing 12 months (TTM) FCF by $328.284 billion in TTM sales. This is based on Seeking Alpha's analysis of Alphabet's TTM operating cash flow, capex, and sales data.
It's also important to note that the company said during the earnings call that its ongoing capex spend will be slightly lower at $12 billion, instead of $13.1 billion.
Therefore, going forward, we can use this to project the company's FCF based on analysts' sales forecasts. For example, based on Seeking Alpha's survey of over 45 analysts' forecasts, Alphabet could reach $347.18 billion in sales in 2024 and $386.11 billion in 2025. That means the run rate average for the next 12 months (NTM) is $366.65 billion.
We can be confident that Alphabet will generate 18.5% in FCF margins going forward. Here is why. In Q2 its operating cash flow margin was 31.5% (i.e., $26.65b/$84.7 in sales). Therefore, operating cash flow in the next 12 months could reach $116 billion (i.e., 0.315 x $366.65 billion). Then, after deducting $48 billion in capex spending (i.e., $12 billion x 4), its FCF could be $68 billion, or 18.5% of forecast revenue of $366.65 billion.
As a result, NTM FCF could reach $67.83 billion (i.e., $366.65b x 0.185). This is useful to set a target valuation.
Setting a Target Valuation
One way to do this is to assume that the company could pay out 100% of its FCF as a dividend. What would its dividend yield be?
Right now the dividend yield is just 0.48% (i.e., $0.80/$166.68. (Last quarter the company paid out its first quarterly dividend of 20 cents and this quarter and said it would do so every quarter, so the annual rate is 80 cents).
However, the dividend cost $2.466 billion, or just 18.3% of its $13.454 in FCF. That is less than one-fifth of FCF. In other words, if the company were to pay out 100% of its FCF, the dividend yield would rise by almost 5 times (i.e. 1/0.183 = 5.46x).
So, if we multiply GOOG stock's 0.48% dividend yield by 5.46x the yield could become 2.46%. This implies that the stock's valuation in the next 12 months would rise to $2.757 trillion. That is seen by dividing the NTM FCF forecast of $67.83 billion by 2.46% (i.e., $67.83b/0.0236 = $2,757 billion). That is 33% over today's market cap of $2.07 trillion.
Target Price
In other words, GOOG stock could be worth 33% more than $166.68, or $221 per share.
Here is another, more conservative way to look at Alphabet's valuation. In the past year, the company has generated $60.787 billion in FCF (see above) and its market cap today is $2,070 billion. That means the market is giving the stock an FCF yield of 2.90% (i.e., $60.787b/$2,070b = 0.029).
Therefore, applying a 2.90% yield against my NTM forecast of $67.83 billion results in a market cap forecast of $2.34 trillion (i.e., $67.87b/0.029 = $2.340 billion). This is still 13% higher than today's market cap of $2.07 trillion. In other words, GOOG stock could be worth $188.34 per share.
The bottom line is that given analysts' sales projections and its TTM FCF margin history, GOOG stock could be worth between 13% and 33% more over the next year.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
