Since Google for Youtubetech giant empire Alphabet (NASDAQ:GOOG) is huge. But lately, Alphabet’s stock price has been falling. It’s down 25% this year, although that still pushes it up 8% over the past 12 months.
Is the fall in the share price a boon? Or does this indicate potential problems for Alphabet shareholders?
Why I think Alphabet could be a great investment
My approach to investing mirrors that of Warren Buffett. He seeks to buy companies with excellent long-term trading prospects when their shares are trading at attractive prices.
Before we get to the price part of this equation, it’s worth explaining why I think Alphabet might be the kind of great company with a sustainable competitive edge that I’d be happy to buy and keep for my wallet.
First, it operates in a large market that is set to continue to grow. In fact, Alphabet is active in several business areas. Many of them, from digital search to mobile phones, are expected to experience continued growth in the years to come.
In these areas, Alphabet has built a strong competitive advantage. Its users interact with Alphabet services so frequently that the company has developed a deep understanding of them. This allows it to offer them services tailored to their individual user profiles. Moreover, its technical expertise means that many of its services are preferred by users over those of competitors. For example, in a given month Google typically handles over 90% of global search queries. Such performance creates a virtuous circle for the company. The more people use its services, the more quality results they get, which encourages them to use it even more in the future.
As a business model, this is very scalable. Optimizing technology costs money, but the costs can be spread across billions of users. It’s good for profitability. Last year, Alphabet reported operating profit of $79 billion.
Is the Alphabet share price attractive?
Clearly, I find Alphabet’s investment case compelling. But what about its stock price?
After all, although it fell during the recent tech market swing, it’s still higher than it was a year ago. Look further and its performance is even stronger. Over the past five years, Alphabet’s share price has more than doubled.
Despite this, the company’s price-to-earnings ratio is around 20. That’s not cheap, but it’s also not unusually high for a growth-oriented tech stock, in my opinion. Indeed, one of the reasons why the P/E ratio looks attractive is Alphabet’s growth. Over the past five years, as the stock price has more than doubled, Alphabet’s earnings have increased by 231%. Thus, the P/E ratio decreased.
This usually suggests that a company’s stock is getting cheaper. But why should Alphabet shares get cheaper? One reason could be concern over future growth rates, given that this company already has annual revenues of $258 billion.
It’s a valid concern in my opinion, but Alphabet has shown that it can grow revenue significantly, even from a high base. Indeed, last year’s $258 billion was a 41% jump from the already huge numbers of the previous year. The company has also shown that it can grow profits before revenues. Thanks to the scalability of its business model, I expect that to continue to be the case.
Another explanation for Alphabet’s stock becoming more affordable is valuation issues. But it has a historic P/E ratio of 20, with the prospect of continued strong growth in earnings per share. This means that the prospective C/E ratio from a mid-term perspective is probably right in the mid-teens, or possibly lower. For a high-growth, profitable company with the kind of competitive advantage that Alphabet enjoys, that seems cheap to me.
I think the main driver behind the drop in Alphabet’s share price could simply be general investor sentiment. There was a sell-off in many tech stocks, pushing prices down. This hit Alphabet, one of the biggest names in tech.
A buying opportunity
So if I think Alphabet has great business and an attractive stock price, should I add it to my portfolio?
While I think Alphabet’s stock price seems like a good value, in fact there are some risks that come with the business. Perhaps investors priced them in when they drove the stock price down. Despite its growth so far, Alphabet may struggle to succeed over the next decade like it has over the last. Technological evolution is accelerating and the company seems stronger in some areas than in others. Search is popular with computer users. But young people whose primary digital tool is their phone may prefer to find information in other ways, such as through social media recommendations.
Size can also be a barrier to profitability. As it happened to Microsoft while its market position was very strong, Alphabet could be a target for regulators who wanted to break it up. This could eat up management time and prevent managers from continuing to grow the business, even if the business remains intact.
My next move on Alphabet stock price
Despite these risks, I continue to see value in Alphabet’s stock price after its recent 25% drop.
I would consider buying the stocks for my portfolio and holding them for years. What I see as the competitive advantages of Alphabet’s business will hopefully become even more important over time to help the company grow profits. Adopting a long-term investment mindset, I think buying Alphabet shares at the current price could hopefully prove rewarding for me.