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AnalysisU.S.

How to analyse Alphabet (Google) as a stock investor

Among the FAANGM stocks, Google has always been my favourite. Since discovering its ground-breaking search engine in 1998 in the early days of Internet, to jumping onto Gmail when it first launched with 1GB of free space (Hotmail only offered 2MB back then), Google has pretty much been a part of my everyday life.

Today, I still search on Google, use Gmail, navigate on Google Maps, and surf YouTube on an almost daily basis. Unlike social media, I would find it hard or extremely inconvenient to live without Google and its services.

Since its listing in August 2004 to end-2021, Google’s stock price has returned an amazing 5,670%. This means every $10,000 invested would have grown into $577,000. Google has clearly been a phenomenally successful company over the last 20 odd years. But, as an investor, how do you evaluate its business performance moving forward?

The best place to keep track of Google’s performance is by going through its quarterly results whenever they are released. However, if you’ve always found the company’s earnings press releases confusing, then this article will help you zoom in on the most important information you need to know when analysing Google/Alphabet.

1. Revenue growth

The first thing to note is the company’s revenue growth on a year-on-year basis. For example, Alphabet reported US$75.3 billion in quarterly revenue for Q4 2021, a 32% increase from Q4 2020. And it reported US$257.6 billion in full-year revenue for FY2021, a 41% increase from FY2020.

Chart: moomoo

Revenue growth is welcome but what is more important is to note the rate of revenue growth. Alphabet typically grows its revenue by around 20-25% a year, so a 41% increase means that the company did exceptionally well this year.

However, if revenue growth falls significantly, it’s important to find out the reason for the slowdown and whether it’s a short-term issue or a long-term structural problem. For example, Alphabet’s revenue growth fell to 12.77% in FY2020 when the pandemic emerged as advertisers cut back on spending. But that was a temporary concern as advertisers dialled up spending once the pandemic eased.

2. Segmental revenue

Alphabet (Google’s parent company) comprises several business segments including Google Services, Google Cloud, and Other Bets. Within Google Services, it’s further broken down into sub segments:

  • Google Search & other consists of advertising revenues generated on Google search properties and other Google owned and operated properties like Gmail, Google Maps, and Google Play
  • YouTube ads consists of advertising revenues generated on YouTube properties
  • Google Network consists of advertising revenues generated on Google Network Members’ properties participating in AdMob, AdSense, and Google Ad Manager
  • Google other consists of revenues from net sales of apps and in-app purchases and digital content sold in the Google Play store; hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; YouTube non-advertising, including YouTube Premium and YouTube TV subscriptions and other services; and other products and services
Source: Alphabet

As you can immediately tell, Google Services (specifically advertising) is Alphabet’s most important segment and contributes the majority of the company’s revenue.

Knowing this, it’s important to keep abreast with the growth of the overall digital advertising industry and Google’s position within it. As of 2021, Google remains number one followed by Meta and Amazon.

Source: Ebiquity

Alphabet’s next segment is Google Cloud which is the third largest cloud provider in the world. Google Cloud generated US$5.5 billion in revenue in Q4 2021 and growing nicely. At the moment, this business is still turning an operating loss.

Source: Alphabet

However, losses have been narrowing over the years, and Google Services generates more than enough profit to cover the cloud losses. Alphabet will continue to scale Google Cloud and expects the segment to be profitable in the long term.

‘While Cloud operating loss and operating margin improved in 2021, we plan to continue to invest aggressively in Cloud given the sizable market opportunity we see. We do remain focused on the longer term path to profitability and, over time, operating loss and operating margin should benefit from increased scale.’ – CFO Ruth Porat

3. Traffic acquisition costs

We already know that Google is the world’s largest advertising platform. The sheer scale of Google’s operation means that billions of people every day watch ads on YouTube and click on ads on Google’s search engine and vast network of partner sites. However, a lot of this traffic doesn’t come for free; Google has to pay to acquire it.

For example, Google paid Apple US$15 billion in 2021 to remain the default search engine on the iPhone. This ensures that the one billion iPhone users around the world will likely continue to use Google Search and click on Google ads. Google also pays website owners a share of revenue to display Google ads on their website.

The amount that Google spends to attract all this traffic is called traffic acquisition costs (TAC). The less Google spends on TAC to attract the same amount of traffic, the better. But TAC is expected to increase over time as the advertising segment grows larger. What is more important is to compare Google’s TAC as a percentage of its advertising revenues.

In Q4 2021, Google spent US$13.4 billion on TAC, and generated US$61.2 billion in advertising revenues. This gives TAC rate of 22%. This basically means that Google spent 22 cents on average to earn a dollar of advertising revenue. What we want to monitor is that TAC rates don’t shoot up too high and remain constant most of the time.

 Q1 2020Q2 2020Q3 2020Q4 2020Q1 2021Q2 2021Q3 2021Q4 2021
TAC Rate22%22%22%23%22%22%22%22%
Source: Alphabet

As you can see, Google’s TAC has remained remarkably consistent over the last eight quarters despite advertising revenues almost doubling over the same period. This indicates that Google is managing its TAC very well, and that its advertising revenue growth is sustainable.

4. Other income

Sometimes, companies may have items that temporarily boost or depress their net profit. Because these items are typically one-off and not representative of the core operating business, it’s best to remove them. In Alphabet’s case, its gain (or loss) on securities can run into the billions and significantly distort its earnings.

For example, Alphabet made a considerable paper gain of US$4.8 billion on equity securities in Q1 2021, but in the same quarter the previous year it made a loss of US$814 million.

Source: Alphabet

Warren Buffett himself has previously highlighted how these fluctuations in the market can significantly distort a company’s earnings (in this case, his own):

“Those market gyrations led to a crazy 1,900% increase in GAAP earnings!”

The paper gain boosted Alphabet’s Q1 2021 net profit to US$17.9 billion – almost three times its Q1 2020 net profit of US$6.8 billion. The fluctuating value of Alphabet’s investments has no association to the company’s operating performance. But if you simply glanced at the bottom line, it would look like Alphabet tripled its business! Thus, take note of how Alphabet’s net profit is impacted, so you won’t get misled by any wild swings caused by the wider market.

5. Earnings call transcript

Finally, I highly encourage investors to read Alphabet’s earnings call transcripts that are released along with its quarterly results. Or if you are more auditory, you can listen to the earnings call itself, which is also a great option during your drive or commute.

The earnings call reveals the CEO and management’s thoughts about the company’s recent performance and outlook — straight from the horse’s mouth. Oftentimes, you will gain valuable information not found in the financial reports. Analysts from major financial institutions will also ask questions, usually around areas of concern, which will give you more insights into matters that could affect the company moving forward.

Earnings calls are a treasure trove of information. Listening to a few of the most recent earnings calls is great way to get up to speed about a company quickly!

The fifth perspective

It’s important to remember that each company’s business model is different, and how you analyse its performance is unique to the company. Different companies will have their own segments, metrics, and factors to consider as you go through their respective results.

In this case, Alphabet is a relatively simple company to understand; it generates the majority of its revenue through advertising that’s woven through the many Google products and services we use every day. This familiarity will help as you go through the company’s quarterly results and listen to its earnings call.

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This article was written in collaboration with Futu Singapore Pte. Ltd. All views expressed in the article are based solely on The Fifth Person’s independent opinion.

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Adam Wong

Adam Wong is the editor-in-chief of The Fifth Person and author of the national bestseller Lucky Bastard! which made the Sunday Times Top 10 Bestseller's List in 2009 and Value Investing Made Easy which made the Kinokuniya Business Bestseller's List in 2013. In 2010, he appeared on U.S. national television on the morning show The Balancing Act. An avid investor himself, Adam shares his personal thoughts and opinions as he journals his investing journey online.

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