Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), the parent company for Google, is worth $3,330, or 38% more than today’s price of $2,414. This is based on my assessment of its huge free cash flow (FCF) margins and a slightly higher FCF yield. This article will describe how I came up with this valuation for GOOG stock.
Based on the company’s recently released first-quarter earnings report, the company generated $13.347 billion in FCF (see page 7 of the report). This represents 24.1% of its $55.314 billion in sales during the quarter.
We can use this number to estimate the company’s value and whether GOOG stock is worth more than today’s price.
Valuing Alphabet Using FCF Margins
That represents a huge increase in its FCF margin. For example, 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.
Let’s use that margin and apply it to future forecast sales. For example, analysts covered by Seeking Alpha foresee that 2022 sales will hit $275 billion. That will be 16.3% higher than the $236.43 billion forecasts for 2021.
But if we apply the 24.1% margin to the $275 billion 2022 forecast sales, FCF will be $66.275 billion. This will be 55% higher than the $42.843 billion in FCF in 2020. (That $42.8 billion figure can be calculated from the Cash Flow Statement on page 6 of the company’s 2020 earnings release).
Using FCF Yield To Value Alphabet
Next, we can use this estimate for 2022 FCF to derive the company’s market value. For example, right now GOOG stock has a FCF yield of 3.33%. This can be seen by taking the Q1 $13.357 billion in FCF and dividing it on a run-rate basis by the $1.60 trillion market value. Here is how that works: ($13.457 billion x 4) / $1.6 billion = $53.388 billion / $1.6 billion = 3.33%.
Therefore, if we divide the 2022 forecast FCF of $66.275 billion by its market value of $1.6 billion, the forward FCF yield is much cheaper at 4.14%. However, using a 3.33% yield instead, the pro forma market value rises to $2.008 trillion. That is 25.5% higher than today’s market cap.
Moreover, it is likely that by that time the FCF yield will rise to 3%. Therefore, dividing $66.275 by 3% produces a pro format market value of $2.209 trillion. This is 38% higher than today’s market cap.
That puts the value of GOOG stock 38% higher than its recent price of around $2,414, or $3,330. This method of estimating the future of GOOG stock, therefore, is based on a stable FCF margin and applies it to Alphabet’s forward sales. It also includes a slightly better FCF yield than today.
What To Do With GOOG Stock
Analysts believe that Alphabet stock is worth more like me but their estimates are much lower. For example, TipRanks.com reports that 29 analysts have an average 12-month target of $2,785, or 19% higher than today.
This is also typical of other analyst aggregation sites. For example, Seeking Alpha reports that 46 analysts have an average target of just $2,673, or only 10.4% higher.
Clearly, my model ends up with a much higher price target at $3,330 than most other analysts. Whether this is a good thing depends on whether you think analysts, in general, have been successful in predicting GOOG stock.
But keep in mind as well that most other stocks have at Alphabet’s level have a similar FCF yield. I pointed this out specifically in my article on Google last month.
Therefore, I think it is better to use a simple model like my FCF margin – FCF yield model. This is a better way to value a highly profitable and cash flow generating company like Alphabet.
It is easy to keep track of Google’s FCF margins each quarter. Then you can decide if the FCF yield should improve, i.e., to fall, over time. So the model depends on the FCF growth, the FCF margins and the FCF yield – all of which are very stable at Alphabet. As a result, look for GOOG stock to rise 38% to $3,330 over the next year.
On the date of publication, Mark R. Hake did not hold a position in any security mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.