Despite his fortune at Apple, Buffett still regrets missing out on Google

2022-07-10 0 By

In 2017 and 2019, Warren Buffett said he regretted not buying Alphabet, Google’s stock.This is despite the fact that Google fits all the characteristics he looks for in a perpetual compound – a wide moat, a monopoly position in the economic ecosystem and an incredibly high return on capital.Apparently, his reasons for regret are still valid.Not only does Google have a high return on capital, it always finds plenty of opportunities to reinvest large amounts of additional capital.In Buffett’s own words: price aside, the best businesses are those that can use a lot of incremental capital over a long period of time at a very high rate of return.Google’s real earnings, or owner’s earnings, have been better than its accounting earnings.Given its recent decline, Google’s valuation is close to the “Buffett value line.”How to observe Google’s profitability?Google trades at about 25 times earnings, accounting earnings under GAAP rules, but that doesn’t reflect its true profitability.In Google’s case, the accounting earnings significantly understated its true profitability.A company that generates a lot of free cash flow might do all sorts of things with that cash, waiting for investment opportunities, buying back shares, etc.Free cash flow can provide financing flexibility because they are not dependent on capital markets to support their expansion.Capex can be further divided into “maintenance Capex” and “growth Capex”.The former refers to the capital expenditure that the existing assets can maintain the current production and operation level of the enterprise, while the latter is mainly used to purchase new assets or expand the scale of existing assets.We can imagine a pool that has both water and water, and the water represents depreciation, and if the water level is kept constant, the water can be viewed as a maintenance capex, and if the water level is rising, the additional water can be viewed as a growth capex.The owner’s surplus should be free cash flow plus some of the capital expenditure (ie, growth capital expenditure) used to fuel growth.Therefore, OE is even higher.The chart below shows Google’s EARNINGS per share, free cash flow per share (” FCF “) and owner’s earnings (” OE “) under GAAP rules over the past few years.FCF can be seen to be either very close to or higher than EPS, which already shows signs of a difference between EPS and OE under GAAP rules.Google’s different analysis of the Key to The Google OE is to delineate the growth CAPEX from the maintenance CAPEX.The reason growth capital expenditure should not be considered a cost is that it is optional.It’s a key insight that investors like Buffett have been promoting for decades.The chart below shows Google’s growth capex as a percentage of total capex in recent years.As you can see, almost a quarter of Google’s capex in recent years has actually been growth capex, not maintenance capex.The upshot: As the chart above shows, Google’s OE will be significantly higher than its FCF and EPS.In fact, as you can see from the chart below, OE does outperform EPS by about 30% on average, close enough to the 24% growth capex analyzed above.Almost a quarter of CAPEX is a growth CAPEX, and Google is truly an amazing investment company that can use a lot of incremental capital at a very high rate of return even at its current size.Many are worried about a further market correction or even a crash — and with good reason.Today, even after a correction of nearly 10 per cent, market valuations remain near record highs.The chart below compares Google’s current valuation with its historical valuation and that of the market as a whole: At current prices, Google’s accounting EPS is valued at about 25.1 times PE, already below its historical average of 28 times.The Nasdaq trades at about 33.8 times earnings.By reading real economic earnings, Google’s valuation is even lower than it appears.Currently, GAAP based PE is about 25.1 times, and its real economic surplus PE is only about 23.5 times.So in terms of valuation, Google looks cheap compared with the overall market.On the other hand, don’t forget that In terms of debt (basically no debt), profitability, moat and so on, Google is generally stronger than most US businesses.Here’s another valuation metric: PE and RETURN on capital (ROCE) for various Buffett-type businesses.Rather than looking at PE alone, it makes more sense to look at PE in the context of quality.The figure below shows the valuation adjusted for profitability.The green line is what I call the Buffett value line.As you can see, Buffett’s largest holding, Apple, also happens to have the highest return on capital in this group.As you can see, Google’s valuation is now pretty close to that line, especially if you consider its p/E based on owner earnings.First, the pace and extent of economic recovery in the post-pandemic era need to be watched.Despite widespread vaccination campaigns, the economy is steadily reopening.However, the epidemic is far from over and uncertainties such as the Delta and Omicron variants remain.Second, there could also be significant short-term volatility risks.While Google’s valuation is very reasonable, the overall market itself remains near all-time highs and many key macroeconomic uncertainties are emerging.This combination of volatility and high valuation certainly poses some short-term risk to Google’s stock, regardless of its size and business model.Such short-term volatility may be of concern to long-term investors.Finally, there are the risks of antitrust regulation.The Justice Department has been investigating how Google maintains its power in the digital advertising market.The investigations could lead to a second antitrust lawsuit against Google in the near future.So, what then?Google’s valuation is distorted by its heavy investment in growth capex, which has averaged about 24% of its total capex in recent years.In particular: thanks to heavy growth investments, its owners’ earnings (OE) is on average about 30% higher than EPS under accounting rules and its valuation is even lower than it appears.After adjusting for return on invested capital, this is very close to the “Buffett value line”.Finally, since almost a quarter of CAPEX is a growth CAPEX, Google is truly a remarkable compound company that can use a lot of incremental capital at a very high rate of return even at its current size.