From Google to YouTube, the empire of tech giant Alphabet (NASDAQ: GOOG) is enormous. But lately the Alphabet share price has been tumbling. It is down 25% this year, although that still puts it up 8% over the past 12 months.
Is the falling share price a bargain? Or does it indicate potential troubles ahead for Alphabet shareholders?
Why I think Alphabet could be a great investment
My approach to investment mirrors that of Warren Buffett. He seeks to buy companies with great long-term business prospects when their shares are trading at attractive prices.
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Before turning to the price part of this equation, it is worth explaining why I think Alphabet could be the sort of great company with a sustainable competitive advantage I would be happy to buy and hold for my portfolio.
First, it operates in a large market that is set to continue growing. In fact, Alphabet is active in a number of business areas. Many of them, from digital search to mobile phones, are likely to see continued growth in the years ahead.
Within those areas, Alphabet has built a strong competitive advantage. Its users interact with Alphabet services so frequently that the business has built a deep understanding of them. That enables it to offer them services tailored to their individual user profiles. On top of that, its technical expertise means that many of its services are preferred by users over those of competitors. For example, in any given month Google typically handles over 90% of global search queries. Such performance creates a virtuous circle for the company. The more that people use its services, the higher-quality results they get, encouraging them to use them even more in future.
As a business model, this is very scalable. Optimising the technology takes money, but the costs can be spread over billions of users. That is good for profitability. Last year, Alphabet reported operating income of $79bn.
Is the Alphabet share price attractive?
Clearly, I find the Alphabet investment case compelling. But what about its share price?
After all, although it has fallen during the recent tech market wobble, it is still higher than it was a year ago. Look back further and its performance is even stronger. Over the past five years, the Alphabet share price has more than doubled.
Despite that, the company’s price-to-earnings ratio is around 20. That is not cheap but it is also not unusually high for a growth-focused tech stock, in my view. Indeed, one reason the P/E ratio looks attractive is because of Alphabet’s growth. Over the past five years, while the share price more than doubled, Alphabet’s earnings increased by 231%. So the P/E ratio has been getting lower.
Typically that suggests a company’s shares are getting cheaper. But why should Alphabet shares be getting cheaper? One reason could be concern about future growth rates, given that that firm already has annual revenues of $258bn.
That is a valid concern in my view, but Alphabet has shown it can grow revenues strongly even from a high base. Indeed, last year’s $258bn was a 41% jump on the previous year’s already huge numbers. The company has also shown that it can grow earnings ahead of revenues. Thanks to the scalability of its business model, I expect that to continue to be the case.
An alternative explanation for Alphabet stock becoming more affordable is valuation concerns. But it has a historic P/E ratio of 20, with the prospect of continued strong growth in earnings per share. That means the forward-looking P/E ratio over a medium-term perspective is probably just in the mid-teens, or perhaps lower. For a high-growth, profitable business with the sort of competitive advantage enjoyed by Alphabet, that looks cheap to me.
I reckon the main driver for the falling Alphabet share price could simply be broad investor sentiment. There has been a sell-off in many tech shares, pushing down prices. That has hit Alphabet, as one of the largest tech names around.
A buying opportunity
So, if I think Alphabet has an excellent business and an attractive share price, should I add it to my portfolio?
Although I think the Alphabet share price looks like good value, in fact there are some risks that come with the company. Maybe investors have been factoring them in when pushing down the share price. Despite its growth so far, Alphabet may struggle to be as successful in the coming decade as it has been in the past one. Technological change is quickening and the company looks stronger in some areas than others. Search is popular with computer users. But younger people whose main digital tool is their phone may prefer to find information in other ways, for example through recommendation on social media channels.
Size can also be a barrier to profitability. As happened to Microsoft when its market position was very strong, Alphabet could be a target for regulators who want to break it up. That could soak up management time and distract executives from continuing to build the business, even if the firm stays intact.
My next move on the Alphabet share price
Despite such risks, I continue to see value in the Alphabet share price after its recent 25% fall.
I would consider buying the shares for my portfolio and holding them for years. What I see as the competitive advantages of Alphabet’s business should hopefully become even more important over time in helping the company grow profits. Taking a long-term investment mindset, I reckon buying Alphabet shares at the current price could hopefully turn out to be rewarding for me.
