Does Alphabet Inc. (NASDAQ: GOOG.L) trade at a 40% discount?
How far is Alphabet Inc. (NASDAQ: GOOG.L) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking the company’s future cash flow forecast and discounting it to today’s value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. Anyone interested in knowing a little more about intrinsic value should read the Simply Wall St analysis model.
Check out our latest analysis for Alphabet
Step by step in the calculation
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth, and the second stage is lower growth stage. First, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year free cash flow (FCF) forecast
|Leverage FCF ($, Millions)||US $ 77.9 billion||91.5 billion US dollars||108.8 billion US dollars||US $ 131.6 billion||148.4 billion US dollars||162.6 billion US dollars||174.4 billion US dollars||184.3 billion US dollars||US $ 192.6 billion||US $ 199.9 billion|
|Source of estimated growth rate||Analyst x16||Analyst x14||Analyst x6||Analyst x4||Est @ 12.77%||East @ 9.53%||East @ 7.26%||East @ 5.67%||East @ 4.56%||East @ 3.78%|
|Present value (in millions of dollars) discounted at 6.7%||US $ 73,000||US $ 80.4,000||US $ 89.5k||US $ 101.5k||US $ 107.2k||US $ 110.0k||US $ 110.6k||US $ 109.5k||$ 107.3,000||US $ 104.3k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 993 billion
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 6.7%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = US $ 200 billion Ã (1 + 2.0%) Ã· (6.7% to 2.0%) = 4.3 t US dollars
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 4.3t Ã· (1 + 6.7%)ten= 2.2 t USD
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US $ 3.2 t. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 2.9,000, the company looks fairly good value with a 40% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is the cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Alphabet as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 6.7%, which is based on a leveraged beta of 1.088. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. The DCF model is not a perfect stock assessment tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Why is intrinsic value greater than the current share price? For Alphabet, you have to take into account three essential aspects:
- Financial health: Does GOOG.L have a healthy track record? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future benefits: How does GOOG.L’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.