Morningstar analyst Ahmed Khan has raised his Fair Value estimate for Google parent company Alphabet (NAS: GOOG) to $209 from $182 per share.

This reflects his stronger growth expectations for Alphabet's cloud computing arm, as well as an expectation that Google can defend its dominant position in search.

"A conglomerate of stellar businesses"

With solutions ranging from advertising to cloud computing and self-driving cars, Alphabet has become a true technology behemoth, generating tens of billions of dollars in free cash flow annually.

While antitrust concerns around Alphabet's core search business have made headlines, Khan retains his confidence in Alphabet's overall strength. He expects the firm to remain at the forefront of several verticals including search, artificial intelligence, video, and cloud computing.

AI investments safeguard leading search position

Alphabet's core strategy is to preserve its strong advertising business, with most of its advertising revenue coming from Google Search.

To that end, the firm has invested considerably over the years to improve its search capabilities, ensuring that its search engine remains deeply embedded in how hundreds of millions of users access information on the web.

Khan sees Alphabet's investments in AI as a continuation of this effort to safeguard its core product, Google Search. By leveraging generative AI, Google can not only improve its own search quality via features such as AI overviews, but also improve its advertising business by augmenting its ability to target customers with relevant ads.

Khan thinks it is hard to overstate Google's dominance in the search game.

The firm's brand has become a verb and Google has accrued unmatched technological expertise when it comes to search algorithms, pricing mechanisms, and gathering valuable data for its advertising client base.

Khan says that Google Search’s intangible assets also bolster its network effect.

As more users engage with Google Search on account of its technical superiority, it can monetise those users by selling better ads. This then allows the firm to invest more in Google Search to improve its GSE, while also collecting better signals for its advertising clients.

Threat from AI search competition overplayed?

Khan admits that generative search engines, such as SearchGPT by OpenAI, threaten to upend the general search market. But he doesn't see those competitive threats resulting in a material deterioration of Google Search’s excess returns on capital.

He views the multi-billion dollar costs of building a GSE, acquiring customers and developing better ad targeting signal collection act as a barrier to competition. He also believes Google’s own generative AI offerings, such as Gemini, could provide a compelling alternative for customers and reduce churn.

Cloud products to grow in importance

Beyond search, Khan has a positive outlook on Alphabet’s cloud computing platform, Google Cloud Platform (GCP).

He believes increased migration of workloads to the public cloud and an uptick in the deployment and usage of AI are key growth drivers for GCP over the next five years. As GCP scales, Khan sees it becoming a more important part of Alphabet’s overall business, both from a top-line and profitability perspective.

While the Alphabet’s public cloud platform is markedly smaller than Amazon’s AWS or Microsoft’s Azure, it is the third-largest public cloud vendor, controlling more than 10% of this lucrative market.

Khan thinks that GCP would also merit a wide moat on a stand-alone basis, supported by cost advantages and customer switching costs.

Alphabet's continued investments in its cloud infrastructure, including AI, have enabled it to be one of three firms that have a global public cloud footprint. As Alphabet has continued to invest in GCP, the economics of the business have improved dramatically and look set to get even better as the firm expands its customer base.

Once a company, typically a large enterprise, has rolled into GCP, the costs of leaving GCP are significant. While data egress fees have been coming down throughout the public cloud space, the time and expense of application and database integrations has not. Similar to AWS and Azure, Khan thinks the likelihood of customers changing mission-critical technology infrastructure is low.

World-class asset number three

Khan assigns another Wide Moat rating to YouTube, which he views as a streaming giant with an impressive brand, user base, and burgeoning advertising and subscription businesses.

YouTube, which Alphabet acquired in 2006, has more than 2 billion monthly users with 1 billion hours of YouTube content viewed daily on TV alone. YouTube has parlayed its ubiquity to enter the subscription business while its free users, which comprise 99% of YouTube’s user base, are critical for advertising sales. By running a profitable advertising business, YouTube is able to invest in content, such as the seven-year deal to host the NFL Sunday Ticket, and boost its subscription offerings such as YouTube TV.

YouTube also offers Alphabet access to the top of the marketing funnel, allowing companies to create brand awareness that can spark a desire and intent to purchase a product. As a result, YouTube is a key part of Alphabet’s overall advertising business. It allows them to reach users in a medium very different to text-based search.

What might Alphabet shares be worth?

Taken together, Khan thinks Alphabet is worth $209 per share.

His valuation includes a forecast that Alphabet can grow its top line growing at a 10% annual clip over the next five years, while operating margins stay roughly where they are.

Drilling deeper into the firm’s various segments, he expects Google Search to grow at a mid to high-single-digit level over the next five years as the digital advertising market matures and growth rates taper off after a robust few years following the pandemic.

As for Youtube, Khan expects low-double-digit growth over the next five years with a strong advertising business being increasingly supported by a growing subscription business.

Khan views Google Cloud as a key growth driver for Alphabet’s overall business. He projects GCP sales to grow 25% annually on average over the next five years fueled by cloud migrations, increased usage of AI, and additional software add-ons all working together.

At a recent share price of around USD 167, Alphabet shares look cheap relative to Khan's Fair Value estimate. They currently command a four-star rating.

Alphabet

  • Morningstar Rating: ★★★★
  • Morningstar Fair Value Estimate: $209
  • Morningstar Economic Moat Rating: Wide
  • Morningstar Uncertainty Rating: Medium

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.