Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), the parent company for Google, just reported huge gains in earnings and free cash flow (FCF) for Q1 2021. The implication is that the company will continue to produce massive amounts of FCF over the coming year. Based on this, GOOGL stock is worth at least 35% more than today, or $3,253 per share.
Cutting to the chase, Alphabet reported $13.347 billion in FCF during Q1. This was a huge increase over the FCF of a year ago — $5.446 billion. In other words, FCF grew by 145% in just one year.
This has massive implications for GOOGL stock over the coming year.
FCF Growth and Margins
As might be expected, Q1 FCF was lower than the prior quarter ($17.198 billion). The Q4 quarter was much higher due to Christmas sales and search advertising. This seasonal drop in consecutive FCF is typical.
Nevertheless, Google still produced $50.7 billion in FCF in the year ended March 31. This was 75% higher than the $29.1 billion in the last 12 months of FCF that Google generated a year ago by March 2020.
Moreover, FCF margins exploded in Q1. The $13.347 billion in FCF represents 24.1% of Q1 revenue of $55.314 billion. By contrast, a year ago the FCF was just 13.1% of revenue ($5.446 billion / $41.16 billion in revenue). In other words, FCF margins were 84% higher compared with the same period a year ago.
The most profitable companies in the world have very high FCF margins. This includes Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT). Let’s compare the FCF margins of these companies with Google.
For example, Microsoft just reported $17.09 billion in free cash flow for Q1 on revenue of $41.7 billion, for an FCF margin of 41.0%. In Q4 of 2020, Amazon made an FCF margin of 12.4% ($15.6 billion FCF on $125.55 billion in revenue). Apple reported $56.975 billion in six months FCF to March 27 on $201.02 billion in six-month revenue. That works out to an FCF margin of 28.3%.
The average FCF margin of these three large-cap peer stocks (41%, 12.4%, and 28.3%) is 27.2%. Therefore, Google’s FCF margin 0f 24.1%, although slightly lower than the average, is in the same ballpark.
FCF Yield and Implied Comp Valuation
The market grants similar FCF yields to Google’s peers. For example, Microsoft’s annual run-rate FCF is $68.36 billion. Since its market capitalization is $1.97 trillion, the implied FCF yield is 3.47% (i.e., $68.36 b / $1,970 b).
Now let’s evaluate the FCF yield for GOOGL stock. Its annual run-rate FCF works out to $53.39 billion (i.e., $13.347 billion in Q1 x 4 = $53.388 billion). Since Alphabet has a market cap of $1.54 trillion, the implied FCF yield is 3.47%. This is exactly the same as Microsoft’s 3.47% FCF yield.
Using the same calculations results in an FCF yield of 3.63% for Amazon ($62.4 billion/$1.72 trillion) and 5.0% for Apple ($114 billion/$2.26 trillion).
In other words, the average FCF yield for Alphabet’s peers is 4.0%. However, digital advertising competitor Facebook (NASDAQ:FB) has an FCF yield that looks pretty similar to Alphabet. It just produced $7.819 billion in FCF in Q1, which works out to an annual run rate of $31.3 billion. As Facebook’s market cap is $862.5 billion, the FCF yield is 3.63%. This is closer to Alphabet’s 3.47% yield.
So, on average with all four of these comps, the FCF yield is 3.93%, which is close to Alphabet’s 3.47% yield.
Where This Leaves GOOGL Stock
Given Alphabet’s huge FCF growth and high margins, I suspect that over time the FCF yield level will fall to 2.5% from 3.5%. This implies that its FCF will be more highly valued by the market.
For example, at 2.5%, Google’s $53.388 billion annualized FCF will be worth $2.1355 trillion in market value (i.e., $53.388 b / 0.25 = $2.1355 trillion). This implies that GOOGL stock will rise in value by 38.67% (i.e., $2.135 trillion / $1.54 trillion market cap today).
However, given that Alphabet has a slightly lower FCF margin than its peers (24.1% vs. 27%), I think the valuation gain will likely be closer to 35%. This means that GOOGL stock is worth 35% more than today, or $3,253 per share.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.
