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Alphabet (NASDAQ:GOOGL,NASDAQ:GOOG) posted impressive revenue and earnings, albeit at lower levels than a year ago. However, I am most impressed by its free cash flow (FCF) growth, which I think will push GOOGL stock much higher.
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For example, revenue was down 2% for the quarter to $38.3 billion from the prior year. And net income was down 30% to $6.96 billion. Earnings per share (EPS) was down slightly less, by 28.7%, as the company repurchased shares.
But the gains in FCF this quarter will likely push GOOGL stock significantly higher.
Google’s FCF Growth Was Impressive
That is what I like to focus on. The free cash flow growth seen in the company’s Statement of Cash Flows. FCF is equal to operating cash flow less capital expenditures (capex). I think for a large company like Alphabet, FCF is a more reliable and more true measure of its profitability.
FCF actually rose during Q2. It grew to $8.6 billion, up from $6.5 billion a year earlier. That represents actual cash profits growth of 32.3% over the prior year, a significant $2.1 billion increase in its free cash flow.
Even the first half of 2020 had positive FCF growth. For example, FCF in 2020 was $14.05 billion. But last year it was $13.86 billion. That $185 million increase represented positive growth of 1.3% over the two six-month periods.
Moreover, Alphabet’s latest quarter showed a very high margin in terms of its FCF. For example, the $8.6 billion in FCF represents 22.5% of its $38.3 billion in sales for the quarter.
That means for every $1 billion in revenue the company generates, it keeps $225 million which it can add to its cash pile or use to buy its stock or other companies. On an annualized basis, this FCF represents $34.4 billion, or 3.4% of its $1 trillion market capitalization.
Valuing GOOGL Stock Based on FCF
Let’s compare this FCF yield for GOOGL stock with some of its mega-cap peers.
In its most recent quarter, Facebook (NASDAQ:FB) posted $622 million in FCF on $18.687 billion in sales. That works out to a 3.3% FCF margin. But FB stock has a $722 billion market cap, so it trades with an annualized FCF yield, based on its Q2 figures, of 0.3%, i.e., less than 1%. That implies a much higher valuation than Alphabet’s.
Amazon (NASDAQ:AMZN) generated $13.15 billion in FCF in its latest quarter. That represents 14.8% of its Q2 $88.9 billion in revenue. But AMZN stock has a $1.56 trillion market value, so its annualized FCF yield, based on its Q2 numbers, is 3.37%. That is close to the GOOGL stock FCF yield of 3.4%.
Lastly, Microsoft (NASDAQ:MSFT), made $13.9 billion in FCF during Q2. That is a 36.3% FCF margin. Moreover, MSFT stock has a $1.639 trillion market cap, so its FCF yield, based on an annualization of its Q2 FCF, is 3.39%. Again, this is very close to Alphabet’s 3.4% FCF yield.
The average of these three companies’ FCF yield is 2.37%. The median for the three is 3.37%, the same as GOOGL. The in-between of these two metrics is 2.87%.
Therefore, at 2.87%, the FCF yield for GOOGL stock implies a stock market capitalization of $1.76 trillion. This is found by dividing the annualized FCF as of Q2 of $34.4 billion by 2.87%. The implied market cap is 18.8% higher than today.
Here’s what that means: GOOGL stock is worth $1,761.49 per share. That price is 18.8% higher than today’s price.
What to Do With Alphabet
I find it interesting that both Microsoft and Amazon have virtually the same FCF yield as Alphabet: 3.4%. But all three actually have different quality of earnings.
For example, Microsoft has a very high FCF margin: 36.3%. Alphabet makes 22.5% in FCF for every dollar in sales it produces, and Facebook made 3.3%.
However, let’s look at Facebook at little more closely. If we look at both its Q1 and Q2 numbers, the company made $8.065 billion in FCF on $36.424 billion in revenue. So its normalized FCF margin was 22.15 and more importantly, the FCF yield is 2.2%. In other words, FB is not as much as an outlier. It is about as profitable as Alphabet, but FB stock has a slightly lower FCF yield. This means that the market values it slightly higher than GOOGL stock.
Moreover, the average FCF yield for all three of Alphabet’s mega-cap comps is now 3%, not 2.37%. That effectively reduces the prospective price target for GOOGL stock to $1,684.66.
However, this still represents an attractive potential gain of 13.6% from today. But it is a more intellectually honest and reliable estimate than my prior number. A patient investor in GOOGL stock will likely earn this return over the next year or two.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here.
The post Alphabet’s Surging Free Cash Flow Growth Will Push Its Value Higher appeared first on InvestorPlace.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
