Alphabet (GOOGL -0.52%) has underwhelmed investors over the past year as it appears to have fallen behind key rivals in the rush to monetize a new generation of artificial intelligence (AI) software. While the stock has performed well with nearly 50% returns over the trailing 12 months, it's lagged its large-cap tech peers and now trades at a discounted valuation relative to that group.
That relative discount creates a compelling opportunity. The market appears to be overlooking a potentially enormous competitive advantage for the company that could translate to major growth and strong cash flows down the road.
Alphabet's AI business is getting a discount valuation
Alphabet's valuation hasn't kept up with some of its large-cap tech peers, such as Microsoft (MSFT -1.01%), Meta (META -1.74%), and Nvidia (NVDA -5.50%). Its forward price-to-earnings (PE) and price-to-free-cash-flow ratios are lower than many of the comparable stocks in the sector.
GOOGL PE ratio (forward) data by YCharts.
That discount valuation is likely driven by the company's early performance in the AI boom that began in 2023. The company's generative AI product, Gemini, faced some issues with accuracy upon launch last year, and it once again came under scrutiny following the disappointing results from its image-generation and chatbot products.
Investors clearly think that AI is among the most important determinants of future performance for tech companies, so any hint of weakness on that front can wreak havoc on share prices.
Image source: Getty Images.
There's also speculation that Google's dominance in search could be at risk. AI-enhanced search products are being rolled out by Microsoft and other challengers.
Google still holds nearly 90% market share in the U.S., which is a strong fundamental indicator for the time being. However, that extreme level of dominance means that there's a lot more room for contraction than for growth.
Its market share could plausibly erode in the face of stiffer competition. Technology is going through a transformation, and these inflection points frequently shake up competitive positions. That's bad news for incumbents.
Google Search accounted for 55% of Alphabet's total revenue in its most recent quarter, so there would be serious financial ramifications if competitors were able to steal market share. That seems like reasonable justification for a discounted valuation. There are substantial operational risks for the company to navigate, and investors shouldn't ignore them.
However, discounted valuations can create attractive opportunities. Investors are focused on Alphabet's possible pitfalls, but the company also has enormous untapped potential that the market is willing to overlook right now. If this tech leader can effectively leverage its competitive advantages over the next decade, then this valuation will probably look surprisingly cheap in retrospect.
Alphabet's major advantage in AI
Alphabet hasn't quite lived up to the market's lofty expectations recently, but the AI software boom is still in its relatively early stages. Broad adoption of the next generation of this technology is still a few years down the road. No companies are monetizing the latest AI tools at a massive scale quite yet, and the true winners won't be determined until the industry matures a bit.
Alphabet has time to completely redeem itself from any missteps to date, and it has a key competitive advantage that can help it bridge the early gaps that seem to have formed. AI needs to be trained by analyzing information, so the software's capabilities are ultimately limited by the quality and quantity of data to which it has access.
Even if Alphabet has fumbled its early attempts to roll out new products for the public, the company collects a staggering volume of proprietary data that has very few rivals, if any at all.
Google's dominance in search provides unique insights into people's thoughts and questions. Gmail has nearly 30% market share with 1.8 billion users, and Google Calendar is estimated to have more than 500 million users. Google Workspace has more than 3 billion active users per month.
Netflix (NFLX 0.06%) is said to lead the streaming market with 260 million subscribers, but Alphabet's YouTube dwarfs that reach with 2.7 billion monthly active users. It also has a popular maps system that tracks the movements of many users, along with the world's most popular operating system for mobile devices.
Alphabet has unparalleled access to information regarding people's activities, thoughts, inspirations, preferences, and tendencies. It has the potential to create unique consumer and business profiles that will enable all sorts of value creation through automation. Given its enormous financial resources and leading cloud-computing infrastructure, this company has all of the puzzle pieces needed to craft effective AI solutions that competitors will struggle to replicate.
It's hard to overlook the discounted valuation being attached to a business with a unique asset that could propel it to the front of a transformative emerging industry. Don't ignore some of Alphabet's red flags, but this green flag is one of the most compelling in the stock market right now.
