Alphabet's Net Income Doesn't Matter Right Now. Follow This Metric Instead.
Key Points
Alphabet delivered a net profit margin above 90%, but it wasn't entirely driven by its business operations.
Unrealized gains from equity investments did most of the work, but the current P/E ratio won't tell you that.
Investors should focus more on net operating income than net income when assessing Alphabet's results.
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Net income is one of the best ways to value a company. It's the metric people use to determine a company's price-to-earnings ratio (P/E) and whether its operations are sustainable. However, Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) has become an exception.
The stock currently trades at a 16 P/E after investors were concerned about rising capital expenditures. Taking this ratio at face value can cause investors to think that Alphabet is far more undervalued than it actually is. Investors should focus on net operating income instead if they want the full picture on how the business is doing.
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Why Alphabet's net income is different
Net income is normally one of the best metrics when assessing a company. It subtracts nonoperating expenses like interest and taxes from operating income. Companies with positive operating income can end up with negative net income if their tax bills and interest payments are high enough.
The flaw with Alphabet's net income is that it includes unrealized gains from investments. It's not some underhanded policy and actually complies with generally accepted accounting principles (GAAP), but that doesn't mean it's a reliable metric when investments do most of the carrying.
That happened when the company reported second-quarter earnings. Its early investments in Space Exploration Technologies (SpaceX for short) and other companies did most of the work. Alphabet reported $112.1 billion in net income compared to $119.8 billion in revenue. That's a net profit margin above 90%.
Operating income, which reflects how much money Alphabet's business actually makes, was up 30% year over year, reaching $40.8 billion. To the company's credit, the second-quarter press release led with operating income and acknowledged that net unrealized gains drove its net income growth rate.
Management's P/E ratio uses the $112.1 billion in the quarter's net income, not the $40.8 billion in operating income. That's what makes its P/E ratio an unreliable metric right now.
Should investors buy Alphabet?
The company still posted tremendous results, showing that its artificial intelligence (AI) efforts are working. Cloud revenue continues to scale up in ways that surprise bulls. An 82% year-over-year jump is very meaningful, and it now makes up more than 20% of total revenue. If growth rates continue, its Google Cloud segment will account for a larger share of future sales, accelerating the company's overall growth.
Although net income is unreliable right now, the 30% jump in operating income shows the company is still boosting profits. Rising capital expenditures are an issue, but that extra spending has translated into strong financial results.
Alphabet still looks promising, especially after the post-earnings dip. However, you must go into the investment understanding that the 16 P/E is too good to be true.
Should you buy stock in Alphabet right now?
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Marc Guberti has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet. The Motley Fool has a disclosure policy.
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