Written by the FALCON Team

Introduction

Following our deep-dive analysis on Netflix (NFLX), we are introducing a new format, covering a select group of companies with a pronounced focus on valuation, relying on the EVA (Economic Value Added) framework. In pursuit of maximizing total returns, two segments of the stock universe are of exceptional importance, which we simply refer to as “EVA Monsters” and “Fallen Angels”, as illustrated below:

Image Source: Author’s Illustration

The fundamental return of every stock (excluding the effect of valuation) is composed of:

Fundamental Return = EVA CAGR + dividend yield + share count reduction

In the case of the aforementioned two categories, the composition of fundamental return is very different:

  • “EVA Monsters”: These are high EVA-growth companies, where the majority of our fundamental return stems from future growth in EVA. Some of these companies are major repurchasers of their shares and most pay no dividends, since they have wonderful reinvestment opportunities.
  • “Fallen Angels”: These are mature businesses that have stable EVA generation capability but lackluster growth. Most have a sizable dividend payout, potentially enhanced by share repurchases.

While both types of investments can yield handsome results, it is readily apparent that “EVA Monsters” have a higher fundamental return than “Fallen Angels”, because they possess much better growth characteristics. Why is fundamental return important? Because the longer you hold a stock, the closer your return will get to this fundamental return. In short: when our aim is to hold a stock for decades, we want “EVA Monsters” in our portfolio.

Once we laid this foundation, we can introduce valuation as the last missing piece of the equation. Let’s see the full investment thesis behind both groups:

Total Return = Fundamental Return + Change in Valuation

In the case of “Fallen Angels”, sentiment change is the primary source of total return. Since reversion to the mean is a one-trick pony, the sooner it happens, the higher our annualized return. The most dangerous pitfall is that this reversion takes too long to happen (if at all), dampening our total return since there is no growth to compensate for the time elapsed. A company can offset some of the “waiting time” with a handsome dividend payout, assuming the dividend is sustainable and that the EVA generation is stable. Simply put: when we buy “Fallen Angels”, we want a huge discount to fair value coupled with a short holding period, hoping for a quick rebound in valuation. Until then, we collect the dividends and when the reversion takes place, we sell at fair value (the sooner, the better). In a nutshell, we don’t want to be stuck holding a “Fallen Angel” for too long, unless it turns into an EVA Monster along the way (which is rather unlikely but cannot be ruled out). Monitoring these positions closely is absolutely essential since some of them may turn out to be value traps while others may transform into EVA Monsters.

When it comes to “EVA Monsters”, we want to buy companies that have lots of EVA growth left in the tank, at a reasonable entry price, and hold them for the long-run. The primary pitfalls are that we either overpay for growth or that the forecasted growth does not materialize to the extent we expected. Both scenarios would sink our total return potential. Thus, we have to leave a buffer in our purchase price in case some of the EVA growth we had anticipated does not materialize, which is painful in not one but two ways: the significantly dampened fundamental return, and the corresponding change in market sentiment (that affects the valuation component of the equation), to adjust for lower future growth.

Note that although the characteristics of these two baskets are largely different, both types of holdings can lead to exceptional, 12-15%+ annualized returns as part of a diversified portfolio. That being said, let’s find out whether one of the most prominent EVA Monsters, Alphabet (GOOG)(GOOGL) trades at an attractive valuation today.

Image Source

So what’s the story with Alphabet?

Alphabet is a holding company that generates the vast majority (~80%) of its revenue via its aggregate Google advertising platforms, including Google Search (~57%), YouTube ads (~10%), and Google Network Members’ properties (~13%) via AdMob and AdSense. The company’s heavy dependence on advertisement spending had a downside effect amidst COVID-19, resulting in a temporary decrease in cost-per-click (the average amount it charges advertisers for each engagement by users), although this was more than offset by continued growth in the number of paid clicks (representing engagement by users). As the economy recovers, however, we expect digital ad spending to accelerate, of which Alphabet is poised to be one of the main beneficiaries.

The company also remains well positioned to grab its fair share of the fast-growing cloud market, with Google Cloud (including infrastructure, data, and analytics, as well as the Google Workspace productivity tools) already accounting for ~8% of the company’s top line, posting a whopping 45% YoY growth, driven by the accelerating demand for digital transformation.

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Alphabet’s other revenues (~12%) consist primarily of Google Play’s app sales and in-app purchases, coupled with YouTube’s non-advertising revenue streams, including YouTube Premium. The segment’s impressive, 35% YoY growth was primarily driven by Google Play, benefiting from an elevated user engagement (partially due to the impact of the pandemic), along with an increase in the number of paid subscribers for YouTube.

Quality Snapshot

Value Creation: What type of moat rating is warranted?

We tend to prefer companies whose businesses are protected by large and enduring economic moats (no matter if we are talking about an “EVA Monster” or a “Fallen Angel”), as buying those companies at the right price generally leads to outperformance, as outlined in our research article. In the EVA framework, the EVA Margin (EVA/Sales) will serve as our ratio to define a company’s moat. A 5% EVA Margin can be used as an indicator for a “good” company, whereas persistence of a 5%+ EVA Margin for 10 years makes a company great and thus “moaty”.

Alphabet’s EVA Margin has been nothing but exceptional during the past 15 years (averaging ~18% over the period), although the increasing portion of revenues derived from non-advertising sources negatively impacted its profitability as of late. We expect the company’s EVA Margin to stabilize around the 15% mark going forward, leading to Alphabet easily passing our rigorous quantitative wide-moat threshold. With Google’s undisputed leadership in the search engine space being intact (dominating both the desktop and mobile space with a global share above 80%), it can leverage the massive amount of data generated to help increase the effectiveness of ad placements, thus continuing to apply a premium pricing to its advertisement offerings. Although the company has been the target of a plethora of litigations to alter its hegemony, we are confident that Google’s market-leading position will prevail, resting heavily on users preferring the convenient, well-established search engine over its distant competitors. Moreover, Alphabet’s Android OS is powering ~75% of all smartphones around the world, further driving ad and other revenue growth across various apps such as Maps, Gmail, and Google Play. In conclusion, such a large and growing user base has created a network effect that is immensely difficult to replicate, thus we believe a wide-moat rating seems fully warranted from a qualitative standpoint as well.

Source: evaexpress.com

Assessing incremental EVA returns

EVA Momentum measures the growth rate in EVA, scaled to the size of the business (measured by its sales). It is the EVA framework’s equivalent for Return On Incremental Invested Capital or ROIIC. Any positive EVA Momentum is good because it means EVA has increased, and it is an indication that it is worthwhile to reinvest capital in the underlying business. Instead of pinpointing any single-year performance, we prefer to look at the long-term trailing averages in EVA Momentum.

Source: Author’s calculation based on data from evaexpress.com

Over the past decade, Alphabet has generated an average EVA Momentum of 7.1%, although the short-term figures are currently skewed by the temporary pressure on EVA induced by the sluggish advertisement environment in light of the pandemic. More importantly, the EVA CAGR forecast stands at ~15% for the next 5 years, implying a rebound to the impressive growth characteristics of the past years. The key driving force behind that (besides general ad spending recovery) is an expected greater revenue contribution from YouTube and Google Cloud (although we must note that the EVA growth will mainly stem from sales growth as we expect the company’s EVA Margin to stabilize around the 15% mark). In conclusion, there is no doubt that every reinvested dollar leads to an immense level of incremental EVA generation for the company’s shareholders, thus Alphabet qualifies as a genuine EVA Monster.

Capital Allocation Snapshot

After looking at the operations dimension, we continue investigating the company through the capital allocation lens. Remember, the incremental return on invested capital (measured by the EVA Momentum) is a crucial element when it comes to the assessment of successful capital allocation by management. If the company can earn a positive EVA by reinvesting all the cash generated by the underlying business, shareholders are better off if the firm retains most of its earnings. In the table below, we have dissected all the possible uses of cash for Alphabet over the past decade.

Source: Morningstar

As opposed to the common misconception regarding IT companies, Alphabet’s business model is rather capital intensive (note the common traits outlined in our Facebook (NASDAQ:FB) analysis), with CapEx amounting to ~37% of OCF over the past decade. Servers and data centers continue to be the largest driver of investments, as the company aggressively deploys capital to support growth in cloud, given the acceleration in digital transformation.

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Alphabet has long been a net issuer of shares to support its employee equity initiative, which it uses to attract and retain the best talent in the industry, by awarding them restricted stock units as part of their compensation package, incurring ~$11B under this cost in 2019. However, as of late, Alphabet’s monstrous free cash flow generation allowed management to announce a $25B share repurchase program (which was completed during Q3 2020), followed by a $28B authorization in July 2020. We expect share buybacks to prevail as a cornerstone of rewarding shareholders, thus in our valuation scenarios we factor in a net share buyback (cleaned from the dilutive effect of employee stock compensation) of ~$15B per year, allowing Alphabet to reduce share count by ~1% annually going forward. Dividends, on the other hand, seem not to be in the cards yet for the company’s shareholders, which we believe is a prudent capital allocation approach, given the massive EVA Momentum achieved on the current level of capital reinvestments.

On the acquisition front, the 2012 Motorola fiasco is luckily rather an exception to the rule, as it was accompanied by a series of bolt-on acquisitions negligible in size compared to Alphabet’s enterprise value. Going forward, although the company has a fortress balance sheet that would allow for major M&A activities, we expect management to continue with a series of tuck-in deals rather minor in size (e.g. the pending ~$2.1B Fitbit acquisition), as organic growth will not disappoint in the foreseeable future.

Valuation

Discounted EVA Model

Although definitely a far cry from a precise tool, a discounted EVA model can be useful as a “vaguely right” (rather than a “precisely wrong”) indicator of the fair value of a company. It is especially effective in extreme cases when the share price and the fundamental performance of the underlying business are largely disconnected from each other.

The reason why we use EVA instead of free cash flow in our valuation model is because EVA better matches costs and benefits, making it a superior measure of corporate performance. It spreads the charge for using capital over the time periods when the investments are expected to contribute to profit and add to the value, instead of concentrating the charge for capital in the one period that the investment is made, as cash flow does. In other words, free cash flow can be negative (caused by large CapEx figures) even if a firm is creating shareholder value, but EVA shows the underlying truth. That being said, the present value of a forecast for EVA is always mathematically identical to the net present value of discounted cash flow.

Note that we are not trying to calculate precise values, as that is an almost impossible endeavor, given the model’s pronounced sensitivity to a plethora of assumptions. For every company we analyze, we compute a “conservative” and an “enterprising” scenario and use those as proxies for our fair value range. In the table below, you can see the EVA consensus estimates through 2025 for Alphabet.

Source: Author’s calculation based on data from evaexpress.com

As opposed to the 5-year consensus EVA CAGR estimate of 15.4%, our conservative scenario assumes an explicit EVA growth of 13% in the period of 2021-2025, tapering off to a more normalized 6.5% in 2026-2030. This EVA expansion stems almost entirely from sales growth, as we believe that there is not much room left for the company to increase its EVA Margin levels from the already stellar ~15% currently. We assume a terminal growth rate of 0% since no company can forever increase its EVA, as opposed to free cash flow, EBITDA, earnings, or any other conventional accounting measure. That is because the number of additional projects where a firm can outearn its true cost of capital (hence increase EVA) is always finite. As a discount rate, we use Alphabet’s 5-year average weighted average cost of capital of 8.1%. The resulting conservative fair value estimate arrives at $1344.

Source: Author’s calculation based on data from evaexpress.com

Turning to our enterprising scenario, we project a more aggressive explicit EVA growth of 15% in the period of 2021-2025, while assuming that the company can maintain a still superb, 10% growth rate in 2026-2030. The resulting enterprising fair value estimate arrives at $1554.

Source: Author’s calculation based on data from evaexpress.com

As a conclusion, our discounted EVA based fair value estimate for Alphabet falls in the range of $1350-$1550, implying that shares are moderately overvalued at today’s levels. At the current price of $1772 (as of November 15), the 10-year baked-in EVA growth rate (from 2021 to 2030) stands at 15%, which we feel is overly optimistic and is something we are definitely not comfortable with.

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Total Return Forecast

When calculating a total return potential for a stock from any given price, we employ the 5-year explicit EVA forecast, our assumptions regarding the dividend and share buybacks, as well as a reasonable premium reflecting the growth characteristics of the underlying business. For the latter, our prime indicator in the EVA world is the Future Growth Reliance (FGR), which is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA. For example, an FGR ratio of 20% says that the firm’s market value would tumble 20% if investors became convinced that it would never be able to increase EVA above its current level. A negative FGR ratio signals that the market is pricing in a decline from the current level of EVA generation, indicating an expectation for future headwinds. To sum up, a higher FGR ratio indicates higher expectations for future growth.

Source: evaexpress.com

In the last 10 years, Alphabet’s FGR was hovering in the range of 25-50% (since the company was able to achieve an exceptional, 15-18% annual growth in EVA), while the FGR is currently standing at 52% as of November 15. Even though we expect Alphabet to continue its outstanding growth trajectory in the next 5 years, looking past that, we believe a more realistic assumption is 5-8% annual EVA growth. The reason why this is of paramount importance is because these expectations determine how big of a growth premium (~FGR) the market will assign to the company’s shares 5 years from now. To remain on the realistic side in our total return forecast, we assume an FGR range of 15-30% from 2025 onwards, gradually tapering off from the historical range of 25-50% until that time. We are also factoring in a 1% annual reduction in the share count thanks to the buyback activity Alphabet has recently put in place. We are using the consensus EVA estimates (as presented above) as a measure of fundamental performance. Based on these assumptions, our annual total return forecast from today’s $1772 level is the following (with the shaded band representing the FGR range of 15-30% around the midpoint value):

Source: Author’s illustration based on data from evaexpress.com

As you can see on the graph, a realistic 5-year annualized total return falls in the ballpark of a dismal 3% from the current price, as Alphabet’s growth premium slowly melts away from the current, exuberant 52% FGR, even as the company is forecasted to achieve a 15% annual EVA growth in the period. This is a prime example of the true risk of investing in enormously large “EVA Monster” companies without a sufficient margin of safety. Even though the fundamental performance should remain outstanding in the foreseeable future, the eventual decline in the reasonable growth premium applied by the market (which is a consequence of slower future growth, as these companies are already gigantic) causes a miserable total return. At least this is what can conservatively be expected.

Summary of the Investment Thesis

We have seen that investing in Alphabet today could bring sobering results, even as the company is of the highest quality and has exceptional growth characteristics. Let’s see what we believe to be an attractive entry price.

With any investment we make, we have a minimum total return threshold of 12%, even after making conservative assumptions in our calculations. This leaves an additional layer of margin of safety since we would be happy with any double-digit return in the long-run. As a result, we would consider an entry price of $1150 to be attractive, from where a 12% annual total return seems reasonable and which also corresponds to a ~20% discount to our $1350-$1550 fair value range. In March this year, the stock price fell as low as ~$1070, at which price we would have loaded up on the stock (unfortunately we missed to do our due diligence on this company prior to the market crash). In the unlikely event of the stock falling all the way below $1000, we would be buying hand-over-fist with a 15% annual total return likely in the cards.

Source: Author’s illustration based on data from evaexpress.com

One more thing

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com