One of the big pitfalls with growth stocks is that they trade at high multiples, and any sudden contraction in growth can take those stocks down significantly. That’s why I prefer to purchase GARP stocks instead. GARP stands for “Growth at a Reasonable Price,” and I think Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) is one such stock.
Ideally, that means a company growing net income at a rate of 15% or higher and trading at a PEG ratio of around 1.0 or so. This is one such approach I’ll be taking in my forthcoming stock advisory newsletter, The Liberty Portfolio.
GOOGL stock has been soaring ever since it went public, but that doesn’t always mean it has been valued fairly by the market. Still, I think it may have become an important core holding in long-term diversified portfolios.
There is a pro and a con about the advertising business that is the basis of GOOGL revenue. In Q3, GOOGL stock earned $22.45 billion in revenue, an increase of 22%. Operating income was $6.78 billion, up 18%, with net income ending up at $9.06 per share.
Alphabet Inc Is Really Only in One Business
We know that Alphabet is primarily only in one business: it is a digital billboard advertising company, albeit one that advertisers love. With revenue up 22%, the message is that GOOGL is, perhaps, the single biggest advertising brand, period.
Alphabet also showed terrific growth in numbers for ads. Paid clicks on those websites run by GOOGL rose 41.9% year over year and rose 10.9% sequentially. Paid clicks for “network members” rose 1%. Aggregate cost per click fell 11%, meaning customer acquisition became ever cheaper.
The downside is that GOOGL is, therefore, not a diversified business. This is always something that makes me nervous. Anything can happen in the world of advertising. While it seems unlikely that a new method of online advertising will supplant GOOGL, it could happen. Likewise, a global or even domestic recession could harm revenue.
This potential risk is offset, however, because GOOG is so efficient. It typically generates about $6.99 billion in free cash flow per quarter. Not only can Alphabet use that money to fund operations and help support GOOGL stock price, but the free cash flow allows GOOGL to plow that money into its “Other Bets.”
This is, effectively, a venture capital division that includes Verily, Calico, Google Fiber, Google X, Google Ventures, Nest and Google Capital.
What Makes GOOGL Stock a GARP Stock?
Cash is one reason, with cash and investments at Alphabet Inc now $72 billion. With about 595 million shares outstanding, GOOGL stock carries some $121 per share in cash. When subtracted from Tuesday’s closing price of $815, Alphabet Inc is thus effectively trading at $694 per share. The market cap is thus $482 billion.
On trailing-12-months net income of $19.1 billion, GOOGL stock is trading at 25x earnings. With net income rising at 18.4% annualized over the next five years, and giving shares of GOOGL stock a 10% premium each for free cash flow, cash position, and brand name, I might normally pay 24x earnings. Ah, but this is a growth stock trading at 25x earnings, giving us a PEG ratio of 1.04.
So, again, if a stock is a growth stock, and if it grows earnings per share at 15% or greater and the PEG ratio is around 1.0, I consider it a Growth at a Reasonable Price stock.
Thus, an investor could purchase Alphabet Inc stock at this stock price, and not be overpaying. However, keep one thing in mind: I believe the market is overpriced, based on FY17 earnings, by as much as 15%-17%. You may want to consider either waiting, selling naked puts or opening a small position here, just to be safe.
Lawrence Meyers is the CEO of PDL Capital, and manager of the forthcoming Liberty Portfolio stock newsletter. As of this writing, he has no position in FB. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
