Analysis of Alphabet/Google: Pricing
Aug 18 · 6 min
TL;DR — Considering only fundamental factors, Alphabet is an extraordinarily profitable and solvent company. You just have to wait for the proper price to start buying. The problem is that this fair price is far from its current NASDAQ quote. However, when the next financial crisis arrives, the price is likely to plummet to this ideal purchase price. So now is the time to save and wait.
In the previous three posts about Alphabet (first one, second one and third one" we have never mentioned anything about its price. We'll do it here for the first time in the analysis. And we're not going to talk about just one price, but two price measures. Although both are important, one price should only receive a minimal amount of attention, while the other should be the main focus and the conclusion result of our analysis.
All we are going to say here about price is going to be based on the Austrian Theory of Capital and in the Value Investing philosophy.
A tale of two prices
There are always two prices to consider in any investment decision. One is the quoted price, and the other is the company's appraised price. It is the quoted price that you shouldn't be paying much attention to, while the company's appraised price will require most of the time of our analysis (or computing time, in case of automated investment).
Once we have both prices, one real price (the quoted price) and the other estimated, the investment decision is reduced to a simple procedure : we will buy only if the estimated price is significantly lower than the quoted price. This difference between the quoted price and the company's price is referred to as the "safety margin" in the value investing philosophy.
No intrinsic-value exists
This value philosophy refers to this appraised price as the company's "intrinsic value". It is from this concept of value that the name of the philosophy itself derives. A very unfortunate name because it goes against the concept of value in economic theory, which considers it subjective and not quantifiable. Moreover, there is nothing intrinsic to that value. This value, which should be more correctly called appraised price, is something totally extrinsic to the company and depends, as we will explain below, on the value (here value, not price) that consumers attribute to the goods and services produced by the company.
The appraised price of a company
A company is nothing more than a set of productive factors (capital goods, natural resources, and labor) acting together to produce goods or services for final consumption, or to produce other capital goods for lower stages of the production structure (the analysis is the same in both cases). The price of the company as a whole is no more than the sum of the price of each of its composing factors.
And how do we calculate the price of these factors? The economic theory of the Austrian School of Economics answered this question a long time ago: the price of a productive factor is just the discounted value of its marginal productivity.
Very briefly, what this theory says is that the price of a productive factor depends on the final value of all that this factor produces throughout its useful life. The value of all produced is ultimately determined by the consumer of the company's products. This value, given by the final consumer, will be translated into a purchase price for the product that will form part of the company's future revenue. Because production factors will contribute to future revenue throughout all their useful life, we must discount this future turnover to the present when estimating the price of the factor.
If you don't understand any of the above, don't worry. This post is too brief to go into detail about the previous analysis. The reader who wishes to brag about understanding all of the above can read chapter 7 of "Man, Economy, and State" by Murray Rothbard. And for the reader who wants to get to the point, all he needs to know is this:
The price of a company, as a set of productive factors, is just its future revenue discounted by a determined interest rate.
Only one important final detail has to be taken into account. Not all the productive factors used by the company are of its property. For example, it may have certain machinery, land or rented premises. Also, the electricity it uses is usually purchased to a third party and not generated by the company using its own capital. Nor does it possess the labor factor (fortunately, slavery was abolished centuries ago). Therefore, we must subtract the price of these purchased factors from the total future revenue before its discounting to the present.
In short, the theoretical price of the company is no more than its future revenue discounted and reduced by the price of the production factor services acquired.
The appraised price of Alphabet
Very nice theory, but how do we apply it to estimate a price for Alphabet? Well, it's relatively simple, but not a very precise process, because it depends on many estimates. From our point of view, the best proxy to estimate this discounted revenue reduced by the factor services acquired is the company's free cash flow.
And how do we know what those future cash flows will be? Impossible to know. All we can do is estimate them, and one of the most conservative ways to estimate them is to assume that future flows will behave similarly to past and recent flows.
Still remains the extremely important detail of choosing the interest rate with which to discount these future flows. We will use here a proxy of the natural rate of interest (we'll write about this rate in a future post). Our current estimate of this interest rate is 8.54%.
Applying all these estimates we arrive at the following estimated price for Alphabet:
7-year average free cash flow: 21.184,43 Million EUR 10-year average free cash flow: 17.502,47 Million EUR Natural rate of interest: 8.54% Alphabet's appriced price: 315,584.12 Million EUR
Alphabet's quoted price
image_tag This part is easy, there's nothing to estimate here. We just need to look at the current Alphabet's quoted price in the NASDAQ exchange and multiply it by the number of shares outstanding.
Share price: 982.68 EUR Shares outstanding: 694.55 Million Market capitalization: 682.520,39 Million EUR
So... do we buy Alphabet or not?
We have already calculated the appraised price of Alphabet and its quoted price. The theory tells us that if you buy at the appraised price you just will get the natural interest rate (this 8.54%) as profit (called interest in this case). So we need to buy below this appraised price in order to, besides taking into account the possible errors made in all the estimates made ("margin of safety"), to obtain what is called a pure profit (the profit obtained above the natural interest rate).
And how much we have to buy below this appraised price? Well, it's a matter of personal choice. Let us be relatively conservative and demand that the market price be at least 25% lower than our estimated price. This way, we arrive at a purchase price per share of:
Apprised price: 315,584.12 Million EUR The margin of safety: 25% Purchase price: 236.688.09 Million EUR Shares outstanding: 694.55 Million Share purchase price: 340.77 EUR Quoted price per share: 982.68 EUR Percentage drop in price to buy: 65.32%
We saw in previous posts that Alphabet was an impressive company from a fundamental point of view, and this is reflected in its current high quoted price. The only chance of buying Alphabet at a reasonable price is to wait for the next financial crisis and see if its quoted price drop this 65% to be able to buy (the good news is that we may not have to wait too long for this next crisis, we will also talk about this in a future post).
Is it reasonable to think that such a huge drop in price might occur in the future? We think so. In the last 2007 crisis, the price of Alphabet on the NASDAQ fell from a peak of $355 to a low of $30, a drop of 63%.
So as soon as you hear the first news of a developing financial crisis, keep an eye at Alphabet's quote and buy everything you can buy if it drops that 65%. You won't get another chance until the next crisis. A collapsing exchange is equivalent to a huge "SALES" sign in a shopping mall. Although you have to be careful with what you buy, as in all sales, with Alphabet you will be on the safe side.