Monday, 30 March 2020

Alphabet DCF Valuation: Value per Share at $924.38

(Acknowledgements and Inspiration: Prof. Damodaran)

Alphabet is among the most followed companies on the Wall Street. A Discounted Cash Flow valuation of Alphabet has been presented below. Free Cash Flow to Firm (FCFF) model has been used to arrive at the value per share and Capital Asset Pricing Model (CAPM) has been used to determine the cost of capital.

Alphabet DCF Valuation FCFF Model

Please click on the hyperlink above to open the model in a new window. Users can feel free to change their assumptions of growth, margins,taxes etc.

Key Drivers of Value and Assumptions

1. Revenues: As of YE 2019 Alphabet's revenues stand at $ 161.86 billions. That is greater than GDP of Ukraine ($ 150 b), Kuwait ($ 137.59 b) and Morocco ($119.04 b). Advertising revenues account for close to 84% of total revenues $ 135.14 billions which is around 40% of the total global digital advertising spend and 24% of total ad spend (both digital and non digital).
(cnbc.com/e-marketer.com)

Google is the most visited website on the face of this planet. To give you a perspective of size (and base effect) India's IT - BPM sector in total generated revenues worth $ 177 billions in 2019. (ibef.org)

Google continues to be the global leader as far as digital advertising is concerned although it faces stiff competition from the likes of Amazon and Facebook among others. Google advertising revenues from developed markets are maturing and expected to stabilize in the next few years.


As you can see in the figure above Alphabet's revenue growth rate has declined from 23.97% in 2010 to 18.30% in 2019. As revenues are softening, Alphabet continues to diversify and look for new sources of revenues. (2017 Net Income has been adjusted for one time repatriation tax of $9099 m).

Assumption: Revenues are assumed to grow at 19.70% per annum for the next five years and gradually recede to the long term risk free rate of USD. To account for the impact of Covid-19
a decline of 10% in revenues has been assumed for the current year and to account for the slowdown of the global economy revenues are expected to grow at 12.5% only in the subsequent year.In the third year, revenues are expected to restore to 19.70% growth rate per annum.

2. Operating Margins: Alphabet's Operating Margins (before tax and unadjusted) have declined from 35.14% in 2009 to 21.15% in 2019. As per Annual Report 2019, the operating margins on non-advertising sources of revenues are lower than that of advertising revenues. Also the operating margins on advertising revenues are set to shrink as the competition intensifies.


Assumption: EBIT after adjusting for operating leases and R & D is at 26.92% for the base year. But due to increased competition pre-tax operating lease and R & D adjusted margin is expected to decline to a (global software entertainment sector margin) of 23.84% by year 10.

3. Tax Rate: Effective tax rate for Alphabet is 13.33% in the current year. In 2017, Alphabet has paid a repatriation tax of $9.9 billion to bring $52 billions in cash from other countries. The operating income has been adjusted for the same.


Assumption: Although the effective tax rate in the current year is 13.3% it has been assumed to gradually rise to a global marginal tax rate of 25% by year 10. 

4. Reinvestment Expenses: Alphabet has $ 120 billions in cash and spends around 15 to 16% of revenues on research and development expenditures. Also Alphabet is actively involved in acquisition of promising young firms and intangible assets such as patents on new technologies.
Alphabet does not intend to be a conventional company as per its founders and management.

Assumption: A reinvestment expenditure of 46.28% of post tax operating income each year has been assumed for the next five years. The reinvestment expenditure is assumed to receed to a steady state rate of 40% per annum by year 10.

5. Cost of Capital: CAPM has been used to determine the cost of equity. The most critical variable in this equation 'Beta' has been obtained by regressing Alphabet's monthly stock price changes against
S & P 500.  Alphabet's cost of equity has been determined using equity risk premiums weighted by the proportion of revenues based on geographies. Alphabet has very little interest paying debt on its balance sheet around $4.5 billions. Using market values for debt and equity its cost of capital comes to 6.33% assuming a marginal tax rate of 25%.

Assumption: The current cost of capital of 6.32% is assumed to grow to 7.50% (which is assumed to be the long run cost of capital for USD) by year 10.

Using these critical inputs the value per share for Alphabet comes to $ 924.38.

You are welcome to agree and disagree and express your opinions!

Data Source: Alphabet Investors Centre, http://pages.stern.nyu.edu/~adamodar/, Google Search!

Investors' discretion is advised.

Friday, 27 March 2020

Diversification of Equity Portfolios

Consider a portfolio of two stocks - Stock A and Stock B. Stock A gives a return of 25% and Stock B gives a return of 15%. Stock A has weight-age of 60% and Stock B has a weight-age of 40%. The correlation between these two stocks is -0.50!

The only problem is that it is difficult to find such stocks in real life with high negative correlations to balance your equity portfolio returns.

The chart below shows the correlation between the BSE Sensex and various BSE Indices since their inception.


The chart below shows the correlation between BSE Sensex and sectoral indices for the last five years. The correlation number has been computed using month on month change since Mar 2015.
While banks, financial institutions, manufacturing, industrials exhibit a high degree of correlation with the benchmark, healthcare, telecom and IT exhibit the least correlation.

Not one sector is negatively correlated to the broad market index. 


 Let us examine the inter-sectoral correlations using monthly changes in S & P BSE indices for the past five years.



Based on these observations no sector seems to have a negative correlation with any other sector.

Stock prices across companies and sectors are positively correlated to each other  and the degree of correlation varies from low to medium to high to perfect. But negative correlation seems to be a text book phenomenon.

So if you come across an imaginary portfolio with stocks that have negative correlations over long periods of time in your finance text book, you need to double check!

Investors need to look for other investment avenues if they really want to diversify their portfolios.

Data Source: https://www.bseindia.com/

Thursday, 19 March 2020

Impact of Covid-19 on Global Economic Growth

(Based on Prof. Damodaran's blog post: A Viral Market Update III)

Global equity markets are reeling under the pressure of Covid-19 as shown in the chart below.




 Most of the benchmark bond yields dipped to record lows and recovered only after governments announced monetary measures to boost liquidity.


At the risk of sounding mercenary, the moot question on everyone's mind is the extent of Covid-19's impact on the global economy. One possible indicator could be the US S&P 500 corporate earnings. Given below is the list of top -5 one year earnings decline in US S & P 500 corporate history since 1960. This can perhaps, give us a range (15% to 40%) of percentage decline in the economic activity across the globe.

The silver lining is that each time earnings declined they bounced back strongly in the subsequent years as shown in the chart below.


Like always, let us hope and pray that the global economy comes back stronger and better after Covid-19!

Thursday, 12 March 2020

Impact of Coronavirus on Indian Stock Markets

Global markets are reeling under the impact of Covid-19 and Indian markets are not an exception.
Between Jan 2020 and today (14: 30 hrs of 12-03-2020) NSE Indian Vix which measures the volatility of stock markets based on option prices has gone up by a whopping 220.85%.


Between Jan 2020 and today (14: 30 hrs of 12-03-2020) the broad based Nifty 50 has fallen by 20.05%. PSU Banks, Metals, PSEs, Energy are among the worst losers whereas Consumption, MNC, Pharma, IT and FMCG have shown some resilience.


One would expect large cap stocks to perform better than the mid cap and small cap but that is not the case. Nifty 50, Nifty Midcap 50 and Small Cap 50 all three indices lost close to 20%.

There is no where to hide at the moment. But every dark cloud has a silver lining. Many companies with good fundamentals are trading at attractive prices. Systematic periodic investments (averaging prices) with a holding period of at least two years can fetch good returns!

Tuesday, 10 March 2020

Correlation between BSE Sensex and S & P 500

 This article examines the correlation between BSE Sensex and S & P 500. If we look at the chart below, there is a definite pattern which is more acute post 2008. S & P 500 can be viewed as a proxy for global cues.


In the figure below, BSE Sensex year on year change has been regressed against S & P 500 and the beta of the regression is 1.0136 with r-squared of 0.25. Although the r-squared is low, the responsiveness of Sensex to S & P 500 is close 1.


If we look at the correlation between the year on year changes in these two indices we have the following results.

So it is safe to conclude that Indian investors do look for global cues and the degree of correlation has in fact increased in the past five years.

Friday, 6 March 2020

Alphabet:Key Financial Ratios 2020


ALPHABET: DIVERSIFYING ITS PRODUCT PORTFOLIO

Slowly but surely, Alphabet is reducing its dependence on advertising revenues. Between 2014 and 2019, the proportion of advertising revenues out of total revenues has decreased from 89.87% to 83.29%. On average, Alphabet invests around 15 to 16% of its revenues on research and development every year. 


As advertising revenues stabilize (from the developed economies), Alphabet is constantly on the lookout for new sources of revenues. The race to the two trillion dollar-market cap is on (!) and the US tech giants are on the prowl with war chests of cash.
 
TRAFFIC ACQUISITION COSTS (TAC)

TAC represents the amounts paid to Google Network Members primarily for ads displayed on their properties and amounts paid to Google distribution partners who make available Google search access points and services. Google distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. (Annual Report 2019)


Google's TAC have increased by about 1% in the past five years from 21.28% to 22.33% as a share of revenues.

GOOGLE ADVERTISING MONETIZATION METRICS


Paid clicks for Google properties represent engagement by users and include clicks on advertisements by end-users related to searches on Google.com and other owned and operated properties including Gmail, Google Maps, and Google Play; and viewed YouTube engagement ads (certain YouTube ad formats are not included in Google click or impression based metrics). 

Impressions for Google Network Members' properties include impressions displayed to users served on Google Network Members' properties participating primarily in Ad Mob, AdSense and Google Ad Manager.


Cost-per-click is defined as Google's click-driven revenues divided by total number of paid clicks and represents the average amount Google charges advertisers for each engagement by users.


Cost-per-impression is defined as Google's impression-based and click-based revenues divided by total number of impressions and represents the average amount Google charges advertisers for each impression displayed to users.


The % change in the paids click is increasing at a decreasing rate and cost per click change % has been decreasing in the past four years. As the number of paid clicks increase the cost per click is expected to reduce as ad revenues stabilize.
The % change in impressions which is being reported from YE 2017 has increased by 9% for the year ending in Dec 2019. The cost per impression has increased by 1% for the year ending in Dec 2019.



ALPHABET: MARGINS and PROFITABILITY RATIOS


1. Gross Profit Margin = Gross Profit/Total Revenues
2. Operating Margin = EBIT/Total Revenues
3. Net Profit Margin = Net Profit/Total Revenues
4. Return on Invested Capital = EBIT*(1-t)/(Book Value of Debt + Book Value of Equity - Goodwill- Cash*) Goodwill has been excluded from invested capital.
Here for the purpose of Cash*, cash, cash equivalents and short term investments have been included.
5. Return on Equity = (Net Income-Interest Income)/(Equity - Goodwill - Cash*)
Here again for the purpose of Cash*, cash, cash equivalents and short term investments have been included. Goodwill has been excluded from equity)

Although, Alphabet's gross margins (55.58% in 2019) are on the rise, we can see that the operating and net profit margins are around 21% by year end 2019. Alphabet invests heavily in R & D and the operating margins on the new segments of revenues are much lower when compared to advertising revenues.Within advertising revenues, You Tube Ads monetize at a lower rate than other advertising revenues. (Remember R & D is not capitalized as per existing accounting standards)



Alphabet's return on invested capital has reduced from 27.52% in 2015 to 21.88% in 2019. We cannot ignore the base effect of Alphabet's advertising revenues of $ 134.81 billions which account for around 30% of global digital ad spend.Google advertising revenues at least from the developed markets are showing signs of maturity. Google is the market leader by far, when it comes to digital advertising revenues but it faces increased competition from the likes of Facebook, Amazon and others for the global advertising pie.



Alphabet's return on equity has declined from 51.96% in 2015 to 47.22% in 2019.
 


ALPHABET: LIQUIDITY AND SOLVENCY RATIOS


1. Current Ratio = Current Assets/Current liabilities
2. Quick Ratio or Acid test ratio = (Cash+ Short term investments +Accounts Receivables)/Current liabilities
3. Cash Ratio = (Cash and Cash Equivalents + Marketable Securities)/Current liabilities
4. Debt to Capital Ratio = Debt/Debt + Equity (Debt includes all interest-bearing debt)
5. Debt to Equity Ratio = Debt/Equity

Alphabet has heaps of cash, so liquidity position is very healthy as shown below. Working Capital as a proportion of revenues has reduced from 0.94 to 0.66 in the past five years.


Alphabet carries very little interest bearing debt on its balance sheet as shown in the figure above.


The only scare with tech giants is that, they may burn their hands at unworthy acquisitions.

(Inspired by Prof. Damodaran, Data Source: https://in.reuters.com/companies/GOOGL.OQ/financials, Alphabet Annual Report 2019)

Up next: Alphabet: DCF Valuation