Why Alphabet Is a Great Company but a Poor Investment
Oct 17 · 6 min
TL;DR — Alphabet's fundamentals are great. The only objection is its current price.
In this post, we will analyze Alphabet exclusively from a quantitative point of view using Gradement. You know Alphabet: the company formerly known as Google, which recently underwent a corporate restructuring to separate its different lines of business between Google and its many other created or acquired companies.
You all know, or should know, that every investment decision has both a quantitative and a qualitative component. Both are equally important. The quantitative part deals with pure accounting data, using analysis techniques to draw conclusions about a company's solvency, profitability, and valuation. The qualitative part involves subjective judgment based on unquantifiable information such as management expertise, business prospects, and economic cycles.
From a quantitative point of view, there are three variables to analyze in every investment decision: profitability, solvency, and price. All are equally important.
Profitability 101
In this first post about Alphabet, we will analyze its profitability. One way to measure profitability is to compare the capital that partners and investors contribute to a company's start-up and operations with the capital they can eventually extract from it. The greater the capital extracted in relation to the capital contributed, the greater the profitability. There is a saying in accounting analysis that no account balance has meaning on its own; it must always be compared with some other balance or accounting variable.
For instance, if you were asked, "Which company is better: Company A, with a $100 million income, or Company B, which earns 'only' $1 million?" The vast majority of people, with no knowledge of accounting analysis, would certainly choose the company with the $100 million income. On the other hand, the correct (and short) answer from an accounting expert would be, "It depends." And that is the correct answer. What does it depend on? It depends on the level of assets the company needs to generate those profits.
Let's say Company A, the one with the $100 million in earnings, has assets of $1 billion. And Company B has assets of $1 million (the same as its earnings). With these levels of assets and earnings, their respective profitabilities are:
- Company A profitability = 100/1000 = 10%
- Company B profitability = 1/1 = 100%
Now it is obvious that Company B is better than Company A. With B, we are annually earning the same amount that we contributed, while Company A is generating only 10% of what we contributed. With Company A, to earn that attractive $100 million, we must first make a $1 billion down payment.
Alphabet's profitability
Let's now calculate Alphabet's profitability. No, you don't need to take out your pencil and calculator; Gradement automatically performs all these calculations for us. If you look for Alphabet Inc. and go to the non-monetary items, you will find an item called Adjusted firm return on invested capital %.
This item is a much more sophisticated measure of profitability than the one we used earlier for Companies A and B. From the total assets contributed by partners and investors, we subtract commercial liabilities and surplus cash. Commercial liabilities are deducted from total assets because they are contributed by the company's suppliers, not by investors or partners. We also subtract "surplus cash," which is the cash the company holds as a buffer but does not use in its daily operations.
Without going into too much detail, this is the function Gradement uses for its profitability calculation:
adjusted operating earnings
Adjusted ROIC = --------------------------------------------------------- x 100.0
total assets - commercial liabilities - surplus cash
And these are the results of applying that function to Alphabet's accounting information:
An impressive 32.96%. Alphabet is currently earning $32.96 for every $100 put into the business. How impressive is this figure? Very. To get an intuition, we have calculated the average and median of this same item for all US companies of a certain size (Size score greater than or equal to 70).
- median = 8.06%
- average = 10.84%
A significant difference from Alphabet's profitability figure.
The attentive reader will have certainly observed that in the previous table, the figure of 32.96% is associated with the end date of the fiscal year (2017-12-31). You might wonder how we can calculate the profitability at the end of the year without knowing Alphabet's total earnings and assets for the full accounting period. While this data is not yet available, we do have interim data for each quarter of the year (except for the last one). With that quarterly information, we can estimate the profitability figure for the end of the accounting period.
The alert reader may have also observed an {est = 83%} beside this figure. This 83 out of 100 is a measure of the confidence level we have in this 32.96% estimate. This figure will get closer to 100 (maximum certainty) as we approach the end of the accounting period and more interim data becomes available to make the estimate.
In addition to this return on adjusted capital investment, there are other ways to measure profitability. To compute its Firm profitability score, Gradement also uses these three other accounting variables:
- The firm free cash return on invested capital
- The adjusted operating margin
- And the operating cash flow margin
In the decimal items section, you can also get the values of these profitability variables for Alphabet:
- firm free cash return on invested capital = 87.98%
- adjusted operating margin = 23.18%
- operating cash flow margin = 83.84%
Using all these measures of profitability, Gradement calculates a Grade of 100 out of 100 for Alphabet—the maximum possible grade. Now, how good is that grade compared to other American companies? We do not need to calculate it ourselves; Gradement provides this information with its Zone relative profitability score.
For Alphabet, the calculated value for this Zone relative profitability score is 98 out of 100. Again, impressive. What does this 98 mean? Relative scores are comparative measures. This 98 is a comparative measure of Alphabet's profitability against the profitability of other American companies. The easiest way to understand this is to imagine there are only 100 public companies in the US. If we were to order those companies from lowest to highest Firm profitability score and assign position 0 to the worst and position 100 to the best, Alphabet would be in the 98th position, with only two companies ahead of it.
Alphabet is, without a doubt, a very profitable company—one of the most profitable in the US (for readers who love statistics, it's in the 98th profitability percentile). But profitability is not the only important factor in the investment decision-making process. Another important aspect is solvency, which will be analyzed in the second part of this series.
A small spoiler for the next post on Alphabet's solvency: it's as impressive as its profitability.