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Shares of Google parent Alphabet are "incredibly attractive" because investors are undervaluing the potential of the technology giant's "other bets" such as artificial intelligence (AI), according to a Schroders fund manager.
Google has been investing in areas from AI to driverless cars and life sciences. When the company reorganized as Alphabet, it began to break out revenues and operating losses for these "other bets" in its quarterly earnings reports.
James Gautrey, a global sector specialist for technology and telecoms at Schroders, ran the numbers over Alphabet's valuation and earnings expectations. He found that the market was bearish on the potential of Google's other bets.
"We know that they are investing about $1 billion a quarter in what they call other bets. So these are the areas that don't really produce any revenue for them, these include their moonshots," Gautrey explained.
"So $4 billion a year, which as you said the market puts the stock is on forward P/E (price-to-earnings) of 20 times."
"Now the core business is growing 25 percent a year in constant currencies, so the market is ascribing absolutely no value at all, in fact it's probably negative – twenty times on minus four billion a year is minus $80 billion and that's a hell of a bet the market is taking that Google is going to fail in all of these things and I suspect that one or two of them are going to prove to be pretty big, so I think the shares are incredibly attractive."
Gautrey explained that the market consensus for Alphabet's 2017 net profit in 2017 is $23 billion, including losses of perhaps $3 billion-$4 billion for "other bets". So the core search business earns $27 billion and if we apply 20 times forward price-to-earnings ratio of 20 times for 2017, that yields a value of $540 billion. A forward P/E or price-to-earnings ratio is a metric that investors use to value a company based on future earnings.
Adding net cash (taxed) of $60 billion to that, yields an equity value of $600 billion.
"With a market cap of just $540 billion, the market is effectively valuing other bets at negative $60 billion. And that is crazy given the potential in these divisions," Gautrey added in a follow-up email to CNBC.
"One could also argue the 20 times multiple on the core is too low given its dominant position and resource. Increasing the multiple would just make the other bets even more negative."