Who doesn’t want to get high-quality stocks as a gift?

It’s that time of the year again when everyone gets into the holiday spirit. This year probably even more so, because there’s already a 20 cm pack of snow outside. Let’s hope that it will stay until the Christmas break to enjoy a truly white Christmas!

This time of the year also means that some of us will be stressed about what to buy for our relatives. I don’t know how it is for you, but it’s getting harder by the year.

And this is not only for me but also for the people that want to buy me a present.

One thing I did learn though; if someone is totally clueless, then expect them to buy black socks for you. In my opinion, getting black socks from someone became a true insult. It doesn’t even lack inspiration, there’s not even color in it!

Actually, I’m curious if I’m the only one with such experience?

But let’s get to the topic of this post.

Why I’m buying stocks as a gift

Last year I started a tradition to buy stocks as a gift for my kids, nephews, and nieces. Their first stock as a gift was a Disney share for about 150 USD each.

Luckily you can still find quite some high-quality originals of stock certificates with a little bit of searching online. Hence, I spend quite some time creating personalized stock certificates for each of them with the help of photoshop.

The idea behind such a present is simple; I would like them to start understanding during their youth what it means to own a part of a business.

Of course, the kids are still relatively small, so they don’t understand yet what such a piece of paper means. So rest assured, in their opinion a toy as an additional gift is always considered the real present. The stock certificates rather end up in the pockets of the parents.

But don’t be mistaken about this. The parents do realize what it means and they know that their kids can claim those shares once they turn 18. The deal is that their kids will have to open a brokerage account and then I will transfer the shares to them.

This ensures that I can still teach them about the power of compounding and owning great businesses when they become young adults. At that time they can then do whatever they want with it, but quietly I do hope that they will continue to hold them and get inspired by starting their own investing journey.

Actually, I’m glad that there are still some years ahead of us because I wouldn’t want them to look at today’s share price of Disney. I could already hear the parents telling my siblings: you see, investing is risky, you only lose money!

Jokes aside, it’s Christmas 2022 now. Let’s discuss an undervalued stock that I will be buying as a gift for them this year.

My stock as a gift for 2023

This year’s choice just has to be Alphabet because my kids are using their products continuously.

Actually, I could say that many of their products are already embedded within their lives:

• they turn on the TV and start watching YouTube as soon as they wake up.
• they are often using one of our Android phones when they want to quickly check something online.
• they are using Google to search things for school via the Google Chrome browser.
• they use Google Meet to connect from time to time with friends and family.
• they use Gmail to create their personal accounts where needed.

Of course, this is all heavily supervised by their parents, but it just shows how much familiarity they have already with their products.

About Alphabet

Alphabet was founded in 1998 as Google Inc. by Larry Page and Sergey Bin. They are the creators of the Google search engine which has taken over the world after they eliminated their early competitors like Altavista.

Google’s pursuit to organize the world’s information and make it universally accessible and useful led them to also acquire YouTube for 1.65 billion in 2006. Fast forward to the fiscal year 2021 and YouTube generated 28.8 billion in ads revenue at an average 23% company-wide operating margin.

This just shows how brilliant the YouTube acquisition was and what a cash machine it has become.

In 2022, these two products have been by far the biggest revenue generators together with Google Network (i.e. AdSense).

But they have many more products and as you can see, also Google Cloud is becoming a very meaningful business right now. Actually, in my opinion, Google Cloud will probably be a big catalyst for revenue growth in the upcoming years.

Larry Page and Sergey Bin have created an amazing flywheel. Have a look at the following incomplete product list which all contribute to ads revenue and further linking within Alphabet’s eco-system:

This is just a true testimony to their focus on innovation because I don’t know many companies that are able to generate so many new products over the last 2 decades.

Interestingly though, failure is also part of innovation, and the following website gives a nice overview of old Google products which have already been retired.

Profitability Alphabet

A great business doesn’t necessarily make it a great stock as a gift!

As an example, there are businesses out there that are very poorly capitalized or rather benefiting the owners than their shareholders. Examples that come to mind are General Electric from 6 years ago (non-Gaap earnings) and Palantir right now (shareholder dilution).

Hence, let’s have a quick look at the three financial statements.

Income Statement

Their revenue and net income growth have been really strong and it’s no wonder that Google is part of the famous FANG stocks.

Their 10-year compounded annual revenue growth (CAGR) is 19.9% and their net income CAGR is 20.1%. These are really strong numbers and there are not too many companies I would assume to grow 20% annually in the upcoming decade. ASML is the only company that quickly comes to mind.

Their net profit margin has been fluctuating between 20% and 30% with an average of 21% during the last decade. The trailing twelve months’ profit margin is 23.7% so I feel there is some margin improvement possible.

Actually, Alphabet’s CEO Sundar Pichai already announced that he wants to make the company 20% more efficient and that could include headcount cuts.

Although the company seems lean compared to its peers, I still believe there is enough fat on the bone after the rapid growth during the most recent COVID period.

Balance Sheet

Their balance sheet is one of the strongest in the world.

They have so much cash on their balance sheet that they can easily buy some additional companies to fuel their future revenue and income growth.

Their balance sheet strength is also recognized by Moodys because the company spots an Aa2 credit rating with a stable outlook.

Their Debt to Equity ratio is about 10% which is one of the lowest in the industry. They are effectively almost debt free and the 27 bln in Long Term debt can be paid off within several months if they really wanted to.

Cash Flow Statement

Alphabet is such a cash machine!

They have been able to double their free cash flow compared to 2019 and I consider this a stellar performance.

Their CAPEX has increased significantly since 2018 and it’s part of their expansion in the cloud market. They had to scale quickly and build additional data centers. Those are very capital intensive, but it typically pays “dividends” in the future if we look at Microsoft’s and Amazon’s cloud performance.

Having said that, please notice the small dip in free cash flow in the trailing twelve months.

A big reason for that is a declining operating margin and a slow-down in growth. At the same time, historical inflation numbers (increasing CAPEX) impacted the world this year.

The slowdown in Revenue and Cash from Operations should come as no surprise because a lot of sales were brought forward in 2020 and 2021 when many companies had to act quickly and become digital overnight.

Capital Allocation

The main quality of a CEO can be reviewed by looking at the person’s capital allocation decisions:

• Investing in Growth
• Investing in Research & Development
• Acquisitions
• Paying Dividends
• Repurchasing Shares

We have seen so far that Sundar Pichai has an excellent track record of investing in growth and R&D. Their track record in acquisitions is a bit less clear to me because most of their acquisitions support their operations which is typically not visible to us.

Did you know for instance that they acquired 255 companies since the start of this century?

Their most well-known recent acquisition was Fitbit for 2.1 billion USD in January 2021. However, their largest disclosed acquisition so far has been Mandiant in March this year. It’s a cybersecurity business for which they paid about 5.4 Billion USD.

Shareholder Returns

Having said that, there are 2 capital allocation decisions left to evaluate the CEO.

Dividends

The first one is the issuing of a dividend. Unfortunately, Alphabet doesn’t pay a dividend and it is neither intending to do so. At this moment in time, they prefer to use their cash to continue investing for growth.

I’m OK with this because I’m not trying to make my kids and siblings dividend growth investors. I rather would like them to fall in love with investing itself.

Do I believe though that Alphabet will pay a dividend in the future? Absolutely!

At a certain moment in time, they will have to reward shareholders with dividends. Especially once growth starts to slow down. This is typical for almost every mature business and good references for that are Apple and Microsoft.

Share buybacks

This leaves us with the last capital allocation decision and that’s share repurchases.

Since 2015 Alphabet has repurchased around 160 Billion in shares. It started slowly, but it really ramped up in 2019.

I guess they had too much money on their balance sheet but I don’t necessarily feel it was money well spent. In the initial years, the shares outstanding were still flat, so it was rather the repurchasing of stock to avoid employee stock compensation dilution.

They then boosted their share repurchases in 2020 to 31 billion and 50+ billion in 2021 and 2022 when Alphabet’s share price was at all-time highs and in my opinion, clearly overvalued.

So to conclude, the company has a strong track record of excellent top-line and bottom-line growth, combined with a healthy balance sheet and very strong cash flow growth.

I think Alphabet’s CEO is a good allocator on the business side of things, but he has still to improve a bit by starting to issue a dividend and become more considerate when repurchasing their own shares.

Catalysts & Risks

So far this article was a lot about looking backward. Let’s now grab our crystal ball and speculate on what the future might bring.

Catalysts

The 3 main catalysts for Alphabet I see are:

1. Further growth and monetization of YouTube by a successful implementation of YouTube Shorts and growth of their YouTube Premium subscription business.
2. Rapid growth of their Google Cloud business. It offers a very attractive proposition to small and large businesses to bring their office suite to the cloud and offers better pricing than for instance Office360 from Microsoft.
3. New profitable product launches from the other bets category. I’m particularly thinking here about investments in Deepmind and Quantum computing in which Alphabet is already a recognized frontrunner.

Risks

The 3 main risks for Alphabet I see are:

• A very deep recession which requires corporates to drastically slash their advertising budget. Alphabet’s majority of revenue comes from advertising and we’ve already seen the short-term impact it had when COVID just broke out. I consider this a relatively high risk for 2023 and 2024 due to the inflationary impact on the wider economy.
• Technology disruption could make Google’s search engine obsolete. An example of that is GPT-4 and its potential implications via ChatGPT. I feel that this is a relatively low risk because Google has an excellent business model in which content creators share in the Revenue Google generates. As an example, ChatGPT is from OpenAI and it has a different business model. Content creators wouldn’t want their content to be accessible without any potential for income generation.
• Increasing regulatory pressure. Alphabet has already a strong track record of settlements and fines due to its monopolistic characteristics. This might hamper its potential for growth, future acquisitions and it might face further restrictions on its ability to operate.

Looking at this, I think that Alphabet’s long-term future is bright, but I do expect short-term headwinds due to a global economic slowdown.

Valuation

So far, we have discussed several aspects of Alphabet in this quick take. More analysis might be needed if you’re not that familiar with Alphabet and if you have never read one of their latest annual reports.

However, I feel that I understand their business well enough based on the data I’ve presented to you today and based on my experience from having analyzed the company before.

Hence, let’s have look at Alphabet’s valuation and what I think it’s worth right now.

Firstly, let’s look at two relatively simple valuation metrics as a litmus test.

Alphabet’s current share price is ~89 USD which gives it an 18 price-to-earnings multiple. This is very attractive considering its historical 20% compounded annual revenue and net income growth.

Another metric I like to look at it when analyzing non-dividend paying stocks is the current free cash flow yield compared to its historical yield.

Historically speaking, Alphabet is trading at a very attractive free cash flow yield right now. We haven’t seen this since 2016 which was the only outlier since 2012.

This tells me that the recent 40% share price decline has offered us an attractive free cash flow yield.

This looks good, right?

So let’s have a look now at my preferred valuation methodology: the discounted cash flow analysis.

Alphabet’s Discounted Cash Flow valuation

I truly believe that any business is worth the sum of its future cash flows, discounted to what it’s worth today.

Recommended watch: How to value a company using Discounted Cash Flow Analysis (DCF)? [for Beginners + Template]

I’m relatively optimistic for the future and that’s why I’m assuming that Alphabet will be able to grow its Free Cash flow with high single digits over the next decade.

This is half of what it has done during the last decade because I believe that it will be harder and harder for the company to continue such growth as it’s already a very large company.

I also expect a 12.5% return as a shareholder during this period of high inflation compared to the 10% discount rate I used when interest rates were nearly at zero.

So if we take these two main assumptions under consideration, then I believe that the stock is fairly valued right now.

To me, this makes it one of those perfect stocks as a gift right now. This is a high-quality business trading at a fair price.

Unfortunately, we haven’t seen so many opportunities to acquire Alphabet shares over the last few years. That’s why I think this will be a great stock as a gift for my kids and siblings.

It’s not only nicely priced right now, but as mentioned before, it’s also a stock that many of them can relate to. At least, when they’re at the right age.

Giving stocks as a gift in practice

It’s hard to give stocks directly to others so we have to be a bit pragmatic here. So let me briefly share with you my very simple 3-step process:

First of all, I will buy all of them a share via DEGIRO. Secondly, I will prepare individual stock certificates by adding their name to it including the number of shares. Thirdly, I will print them, put them in an envelope and place them under the Christmas tree.

I will be using the below Alphabet stock certificate visual as a template. The official Google name on the document will be replaced with Alphabet Inc.

I hope this practical example helps in case you would like to do the same.

Stocks as a gift – conclusion

I find it important to teach the benefits of long-term investing to my kids and niblings while they are still young. They might not yet really grasp it, but I’m sure that over time we will start to have conversations about it.

Actually, I’m already slowly starting to have those with my oldest son.

Last year I bought a share of Disney at a valuation that was probably a bit too rich. Although, buying Disney shares was not so much about the valuation, but rather about speaking to their imagination.

This year I’m just a bit luckier because Alphabet is currently trading at an attractive valuation. I truly hope that this will make my conversations with them much easier 10 years from now.

If my analysis is right, then Alphabet will be a great compounder over the next decade. It should therefore be a very nice example of how a share of Alphabet has generated some nice wealth. Especially compared to having had the money saved in a bank account.

All, I hope you enjoyed this article and that it inspired you to also consider stocks as a gift for your kids and relatives.

Having said that, I’m looking forward to hearing about your thoughts and your approach in the comment section below this article.

Wishing you a Merry Christmas and a Happy New Year!

As always, your Truly,

European Dividend Growth Investor