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.

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