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Alphabet’s estimated fair value is US$242 based on 2 Stage Free Cash Flow to Equity
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Alphabet’s US$196 share price indicates it is trading at similar levels as its fair value estimate
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Analyst price target for GOOGL is US$211 which is 13% below our fair value estimate
Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Alphabet Inc. (NASDAQ:GOOGL) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
View our latest analysis for Alphabet
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
|
2025 |
2026 |
2027 |
2028 |
2029 |
2030 |
2031 |
2032 |
2033 |
2034 |
|
|
Levered FCF ($, Millions) |
US$89.9b |
US$103.3b |
US$117.1b |
US$128.1b |
US$136.5b |
US$143.9b |
US$150.4b |
US$156.4b |
US$162.0b |
US$167.3b |
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Growth Rate Estimate Source |
Analyst x20 |
Analyst x19 |
Analyst x5 |
Analyst x4 |
Est @ 6.55% |
Est @ 5.37% |
Est @ 4.55% |
Est @ 3.97% |
Est @ 3.56% |
Est @ 3.28% |
|
Present Value ($, Millions) Discounted @ 6.9% |
US$84.1k |
US$90.4k |
US$95.8k |
US$98.0k |
US$97.7k |
US$96.2k |
US$94.1k |
US$91.5k |
US$88.6k |
US$85.6k |
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$922b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.6%. We discount the terminal cash flows to today’s value at a cost of equity of 6.9%.
Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$167b× (1 + 2.6%) ÷ (6.9%– 2.6%) = US$4.0t
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$4.0t÷ ( 1 + 6.9%)10= US$2.0t
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$3.0t. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$196, the company appears about fair value at a 19% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Alphabet as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we’ve used 6.9%, which is based on a levered beta of 1.046. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Strength
Weakness
Opportunity
Threat
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Alphabet, we’ve compiled three pertinent aspects you should consider:
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Financial Health: Does GOOGL have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
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Future Earnings: How does GOOGL’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
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Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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