Alphabet's Strong Free Cash Flow Makes GOOG Stock a Value Buy

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Alphabet Inc. (GOOG) generated strong Q1 free cash flow (FCF) that was higher than expected. Moreover, its stable FCF margins, despite higher capex (capital expenditure), imply GOOG stock is worth 19% more at $212 per share. Shareholders can make extra income by selling short out-of-the-money (OTM) puts.
GOOG closed at $178.27 on Friday, June 27, up +2.20%. It is still off its highs from early February. But it still has more to go. This article will show why and how to play it.
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Alphabet's Strong Free Cash Flow Makes GOOG Stock a Value Buy
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I discussed GOOG stock's value in a Barchart article two months ago on April 27, after its Q1 results, 'Alphabet's FCF Results Are Better Than Expected - Time to Buy GOOG?'
Alphabet produced almost $19 billion in FCF last quarter and about $75 billion over the trailing 12 months (TTM). That was despite significantly higher capex spending, mostly on its AI-driven capital spending.
For example, in Q1, capex represented 47.5% of its operating cash flow (i.e., $17.2b/$36.15b), up from just 36.6% in Q4. This can be seen in the table in my April 27 Barchart article.
More importantly, however, its FCF margins are still very strong (i.e., FCF as a percent of revenue). For example, in the trailing 12 months (TTM), FCF represented 20.8% of TTM sales:
$74.78 billion TTM FCF / $359.7 billion TTM sales = 0.208 = 20.8% TTM FCF margin
That was close to the Q1 FCF margin rate of 21.0%:
$18.95 billion Q1 FCF / $90.234 billion Q1 sales = 0.21 = 21% Q1 FCF margin
In other words, Alphabet is still gushing the same amount of cash from sales directly into its checking account despite higher spending on servers, data centers, and AI-driven items.
That helps set a higher valuation for Alphabet.
For example, analysts project $387.81 billion in revenue for 2005 sales and 2006 is +10.6% higher at $428.88 billion.
That means, on a run rate basis, the next 12 months' (NTM) revenue is expected to be $408.4 billion. Now we apply a 22% average FCF margin (i.e., FCF margin rises by 100 basis points):
$408.4 billion NTM sales x 22% FCF margin = $89.848 billion FCF NTM
That is almost 20% higher than its last 12 months:
$90b / $75b = 1.20 -1 = +20%
This could push its present valuation higher. Let's see why.
One way to value GOOG stock is to assume it pays out 100% of its FCF as a dividend. So what would its yield be? The market would likely give it around a 3.50% FCF yield.
(For one, its TTM FCF of $75 billion represents 3.46% of its present $2,165 billion market cap as of Friday).
So, here is how that valuation works out:
$90b NTM FCF / 0.035 FCF yield = $2,571 billion NTM market cap
That is 18.75% higher than today's market cap of $2,165 billion. In other words, GOOG stock is worth almost 19% more at about $212 per share:
$178.27 x $211.75 target price
This is using a 22% FCF margin estimate on the next 12 months (NTM) analysts' revenue estimates and a 3.5% FCF yield valuation metric.
Moreover, analysts tend to agree with this.
For example, Yahoo! Finance shows that 68 analysts have an average price target of $199.62 per share. That is +12% higher than Friday's close of $178.27. Similarly, Barchart shows a mean price target of $200.82 per share.
In addition, AnaChart.com, which tracks recent analysts' price recommendations and targets, shows that 15 analysts have an average of $198.44, and 43 analysts have an average of $206.14 for GOOGL stock.
The bottom line is that analysts all seem to have significantly higher price targets. This helps investors have faith that the underlying value of the company is much higher than today's price.
However, there is no guarantee this will happen over the next 12 months. The stock could stay flat or flatish. So, one way to play it is to continuously sell short one-month out put options with lower strike prices (i.e., out-of-the-money or OTM exercise prices).
That way, investors can set a lower buy-in point, and existing shareholders can generate extra income. Here is how that works.
For example, look at the July 25 expiration period, which is 27 days from now. It shows that the $170 strike price put option contract has a midpoint premium of $2.58 per put contract.
That means an investor who enters a trade order to 'Sell to Open' this put can make an immediate yield of over 1.5% (i.e., $2.58/$170.00 = 0.01518 = 1.52%).
Moreover, this allows a new investor to set a lower breakeven buy-in point, even if GOOG falls to $170:
$170 - $2.58 = $167.42 breakeven
That is 6.0% lower than Friday's closing price of $178.27.
In addition, existing shareholders can short these puts every month to make extra income. For example, the expected return (ER) if GOOG stock stays flat over the next 6 months is:
0.01518 1-mo yield x 6 mo = .091 = 9.1%
In fact, the precise ER is even higher at over 10%, since there are 6.7 periods of 27 days over 6 months:
0.01518 x 6.7 = 0.1017 = 10.17% ER over 6 months
Now, there is no guarantee that a short-seller can make 1.5% shorting 4.6% out-of-the-money (OTM) puts each month. It would not be surprising for GOOG to fall over 5% in 27 days.
But at least the investor has a lower breakeven. After several months of doing this, the investor's buildup of income provides extra downside protection. Moreover, the worst that can happen is that an investor's secured cash is assigned to buy GOOG shares at this lower strike price.
After all, the upside from this breakeven is over 26%:
$211.75 target / $167.42 breakeven -1 = 1.265 -1 = +26.5%
Moreover, the probability of an assignment after shorting these puts is low. The delta ratio is just 27% (see table above). That implies, based on GOOG stock's previous stock price volatility, there is just a 27% chance that it will fall to $170 on or before July 25.
Investors should study Barchart's options learn center tabs to review risks associated with shorting puts.
The bottom line is that Alphabet stock looks undervalued, both from a free cash flow (FCF) standpoint and also based on analysts' targets. One way to profitably and conservatively play this is to sell short OTM puts in one-money expiring contract periods.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com