Alphabet (NASDAQ:GOOGL,NASDAQ:GOOG) posted impressive revenue and earnings, albeit at lower levels than a year ago. However, I am most impressed by its free cash flow (FCF) growth, which I think will push GOOGL stock much higher.
For example, revenue was down 2% for the quarter to $38.3 billion from the prior year. And net income was down 30% to $6.96 billion. Earnings per share (EPS) was down slightly less, by 28.7%, as the company repurchased shares.
But the gains in FCF this quarter will likely push GOOGL stock significantly higher.
Google’s FCF Growth Was Impressive
That is what I like to focus on. The free cash flow growth seen in the company’s Statement of Cash Flows. FCF is equal to operating cash flow less capital expenditures (capex). I think for a large company like Alphabet, FCF is a more reliable and more true measure of its profitability.
FCF actually rose during Q2. It grew to $8.6 billion, up from $6.5 billion a year earlier. That represents actual cash profits growth of 32.3% over the prior year, a significant $2.1 billion increase in its free cash flow.
Even the first half of 2020 had positive FCF growth. For example, FCF in 2020 was $14.05 billion. But last year it was $13.86 billion. That $185 million increase represented positive growth of 1.3% over the two six-month periods.
Moreover, Alphabet’s latest quarter showed a very high margin in terms of its FCF. For example, the $8.6 billion in FCF represents 22.5% of its $38.3 billion in sales for the quarter.
That means for every $1 billion in revenue the company generates, it keeps $225 million which it can add to its cash pile or use to buy its stock or other companies. On an annualized basis, this FCF represents $34.4 billion, or 3.4% of its $1 trillion market capitalization.
Valuing GOOGL Stock Based on FCF
Let’s compare this FCF yield for GOOGL stock with some of its mega-cap peers.
In its most recent quarter, Facebook (NASDAQ:FB) posted $622 million in FCF on $18.687 billion in sales. That works out to a 3.3% FCF margin. But FB stock has a $722 billion market cap, so it trades with an annualized FCF yield, based on its Q2 figures, of 0.3%, i.e., less than 1%. That implies a much higher valuation than Alphabet’s.
Amazon (NASDAQ:AMZN) generated $13.15 billion in FCF in its latest quarter. That represents 14.8% of its Q2 $88.9 billion in revenue. But AMZN stock has a $1.56 trillion market value, so its annualized FCF yield, based on its Q2 numbers, is 3.37%. That is close to the GOOGL stock FCF yield of 3.4%.
Lastly, Microsoft (NASDAQ:MSFT), made $13.9 billion in FCF during Q2. That is a 36.3% FCF margin. Moreover, MSFT stock has a $1.639 trillion market cap, so its FCF yield, based on an annualization of its Q2 FCF, is 3.39%. Again, this is very close to Alphabet’s 3.4% FCF yield.
The average of these three companies’ FCF yield is 2.37%. The median for the three is 3.37%, the same as GOOGL. The in-between of these two metrics is 2.87%.
Therefore, at 2.87%, the FCF yield for GOOGL stock implies a stock market capitalization of $1.76 trillion. This is found by dividing the annualized FCF as of Q2 of $34.4 billion by 2.87%. The implied market cap is 18.8% higher than today.
Here’s what that means: GOOGL stock is worth $1,761.49 per share. That price is 18.8% higher than today’s price.
What to Do With Alphabet
I find it interesting that both Microsoft and Amazon have virtually the same FCF yield as Alphabet: 3.4%. But all three actually have different quality of earnings.
For example, Microsoft has a very high FCF margin: 36.3%. Alphabet makes 22.5% in FCF for every dollar in sales it produces, and Facebook made 3.3%.
However, let’s look at Facebook at little more closely. If we look at both its Q1 and Q2 numbers, the company made $8.065 billion in FCF on $36.424 billion in revenue. So its normalized FCF margin was 22.15 and more importantly, the FCF yield is 2.2%. In other words, FB is not as much as an outlier. It is about as profitable as Alphabet, but FB stock has a slightly lower FCF yield. This means that the market values it slightly higher than GOOGL stock.
Moreover, the average FCF yield for all three of Alphabet’s mega-cap comps is now 3%, not 2.37%. That effectively reduces the prospective price target for GOOGL stock to $1,684.66.
However, this still represents an attractive potential gain of 13.6% from today. But it is a more intellectually honest and reliable estimate than my prior number. A patient investor in GOOGL stock will likely earn this return over the next year or two.