We share the details of our valuation of Alphabet on an Earnings Power Value basis, apply the IW Box framework, and reiterate our view that the investment opportunity is compelling.
We estimate Alphabet's earnings power yield (5.5% without Other Bets) and advance it as “the Google hurdle”, or the opportunity cost for tech investments with similar growth prospects.
We recommend investors to avoid investments in tech businesses with similar or inferior growth prospects (mid to high growth rates, 20%+ ROC) that fail to clear “the Google hurdle”.
As advanced in our initial take on Alphabet (GOOG ) (GOOGL), we believe that at about $1000/share, the investment opportunity is compelling.
Specifically, we wrote:
At $1000/share, we estimate that Alphabet is trading at about 1.25x Earnings Power Value (ex-cash and without “Other Bets”), that is, at a 25% premium of the net present value of the cash flows to shareholders, had management decided to stop investments in growth and distribute all FCF.
And argued that such modest premium over Earnings Power Value (EPV) was justified in view of “exceptional avenues of value-accretive growth”.
In this piece, we share the thought process behind our estimation of EPV. Based on that estimation, we reiterate our view that at $1000/share, Alphabet offers a compelling investment opportunity.
We go on to claim that on an earnings power basis, Alphabet is significantly undervalued relative to most smaller tech companies with similar or inferior growth prospects. We thus advance Alphabet's earnings power yield, or the ratio of earnings power to enterprise value, as the opportunity cost for tech investments with similar growth prospects (mid to high teens CAGR, with ROC in excess of 20%). We dub it the Google hurdle since the yield neglects the value of Alphabet's Other Bets.
We close with recommendations for investors to avoid deploying new funds, and reduce exposure, to tech companies that do not clear the Google hurdle.
Sundar Pichai, CEO of Google (photo: Pradeep Gaur/Mint)
Google's earnings power
EPV is the hypothetical value of a business if it decided to stop investing in growth and maintained those zero-growth earnings in perpetuity.
It is a hypothetical estimation of value in that the business in question may well be investing in growth, which opens a gap between EPV and actual intrinsic value. In particular, a business investing in growth is worth more than EPV if the investment produces returns over cost of capital, and it is worthless otherwise.
For a company like Alphabet, whose earnings power rest on an expanding intangible asset base, EPV provides a lower bound of intrinsic value. And unlike more widespread valuation techniques such as discounted cash flows, EPV does not rely on long-term predictions of very uncertain metrics such as growth rates, capex, and changes in working capital.
On what follows, we estimate the EPV of Alphabet without the Other Bets division. We do that not because we believe that the Other Bets division is worthless, but to put a lower bound on intrinsic value without relying on unduly uncertain estimations. In this particular case, the uncertainty is in the value of early-stage businesses such as Calico, Verily or Waymo.
