Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) reported excellent third-quarter results on Oct. 26, in terms of both revenue and earnings. As a result, its free cash flow (FCF) is now higher than it has ever been in the past. This is likely to power GOOG stock much higher.
In fact, I believe that the stock is now worth almost 33.5% more at $3,905 per share, given its price of $2,925.21 mid-day on Oct. 28. This is higher than my previous estimate on July 30 of $3,554, based on its FCF margin strength.
Since then, GOOG stock has risen a good deal. I expect that Alphabet stock is likely to continue to power ahead as a result of its huge FCF margin gains.
Huge FCF Production at Alphabet
Alphabet reported on Oct. 26 that its revenue for Q3 rose 41% year-over-year (YoY) to $65.11 billion. That also represents a gain of 5.23% over the prior quarter (QoQ) revenue of $61.88 billion.
But more importantly, its FCF rose to $18.72 billion. This is the highest free cash flow that the company has ever produced in any one quarter. For example, last quarter the company produced $16.39 billion in FCF. This represents a 14.2% gain in its FCF on a QoQ basis.
This shows that a quarterly gain of 5.23% in revenue led to a 14.2% gain in FCF. That is a simple definition of operating leverage. In other words, as revenue rises, its FCF will rise exponentially higher, providing leverage to its FCF growth.
But here is another result of operating leverage. In Q3 its FCF margins expanded over Q2 (and even Q1). Here is what that means. If we divide the Q3 FCF of $18.72 billion by its revenue of $65.11 billion, its Q3 FCF margin was 28.74%.
That is a very high FCF margin, but it was also higher than the 26.5% FCF margin in Q2 and the 24.1% margin in Q1, as I described in my article in July.
Therefore, as Alphabet continues to gain operating leverage, its FCF margins will also rise. This is very helpful in setting a value for GOOG stock.
Calculating Value for Alphabet Using FCF Margins
We can use this information about its margins to help set a value for GOOG stock. For example, let’s assume that going forward Alphabet can generate consistent 28% FCF margins.
Analysts now forecast that revenue will rise 17.08% from an estimate of $253.86 billion in 2021 to $297.23 billion by the end of 2022. This is based on Seeking Alpha’s survey of an average of 34 sell-side analysts.
Therefore, we can multiply our 28% FCF margin estimate by the 2022 forecast of $297.23 billion. This results in an estimate of $83.22 billion in FCF for 2022.
Now we can use that figure to estimate the value of GOOG stock. In past articles, I have argued that the easiest way to do this is to use a FCF yield metric. For example, typically GOOG stock has a 3.2% FCF yield, as I have shown in other articles.
Therefore, if we divide the 2022 FCF estimate of $83.22 billion by 3.2%, we get a target price of $2,600.6 billion (i.e., $2.60 trillion). This is substantially higher than the present market cap of $1.94 trillion (according to Yahoo! Finance).
It implies that GOOG stock should be 33.5% higher than today’s price of $2,925.21. That is how I came up with my new $3,905.16 price target for GOOG stock.
What to Do With GOOG Stock
Analysts are all very positive on GOOG stock. They should be. Seeking Alpha indicates that their survey of 46 analysts shows an average price target of $3,301.54 per share. That represents a potential upside of 12.9% over today.
Moreover, TipRanks.com reports that 7 analysts who’ve written on the stock in the last 3 months have an average price target of $3,289.58. That’s 8% over today’s price.
So, you can see that my price target of $3,905 is much higher. Most sell-side analysts typically only have 12-month target prices. My target is simply what the stock is worth, even if it could take up to 2 years (i.e., based on 2022 revenue and FCF estimates).
So, even if my 33.5% price target upside takes 2 years to occur, it still works out to an annual compound return of 15.5%. That is similar to the sell-side analysts (slightly higher), but still represents a very good ROI for most investors.
On the date of publication, Mark R. Hake did not hold a position, directly or indirectly, 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.