Alphabet Inc. could regain its status as a Wall Street darling, but only if it can simultaneously cut costs, return cash to shareholders and reverse the faulty narrative that it is an AI laggard.

Historically, Alphabet has traded at a premium to the rest of the tech market. But in the past couple of years, a discount has opened. According to S&P Global Market Intelligence, Alphabet has the lowest total enterprise value (TEV)-to-EBITDA ratio among the seven tech juggernauts that drove market returns in 2023. On a TEV/revenue ratio, it only trades higher than Amazon.com Inc., which has a high revenue and low-margin retail business.

The valuation gap has persisted even though Alphabet reported solid results and improving margins for the fourth quarter of 2023. Revenue increased 13.5% year over year in the quarter while EBITDA margins expanded from 26.2% to 30.7%, according to Market Intelligence. The stock declined about 8% following the results, only to recover some losses in the aftermath.

"Alphabet remains the most underappreciated Magnificent Seven tech stock, in our view," Dan Ives, a managing director at Wedbush Securities, told Market Intelligence. The Magnificent Seven is a group of mega-cap technology stocks that comprises Amazon, Alphabet, NVIDIA Corp., Tesla Inc., Meta Platforms Inc., Apple Inc. and Microsoft Corp.

From leader to laggard

A major challenge for Alphabet is the perception that it is not only losing the AI race but that its flagship product and cash cow, Google Search, is vulnerable to competition from AI chatbots.

Startup Perplexity AI Inc. in particular is aiming to revolutionize search.

Ironically, Alphabet was once one of the leaders in artificial intelligence, with its researchers publishing a key paper on transformers that revolutionized the field.

"Alphabet has not done a great job of articulating why the views [that it is a generative AI loser] are wrong," Scott Devitt, a research analyst at Wedbush Securities, told Market Intelligence. "This narrative gets built out of thin air and is not supported by actual use."

Google Search and other revenue increased by $12.6 billion year over year in 2023 to $175.0 billion.

– Read about how the Magnificent Seven is driving S&P 500's narrow 2024 rally. – Read about increased regulatory scrutiny around big tech M&A. – Read S&P Global Market Intelligence's report on the 2024 outlook for M&A.

In addition, Alphabet seems to be oblivious to how the market has changed from valuing growth at all costs to financial prudence. "Management needs to move more aggressively in terms of cost discipline, realigning cost structure, and go after growth opportunities," Devitt said.

Ives believes that on a "sum of the parts valuation, AI can add $30 per share to the Alphabet story."

Meta playbook

There is no better example of how being friendlier to Wall Street's views can be beneficial to valuation than Meta. Caught wrong-footed when the AI hype started, Meta swiftly moved to bring its financials in order even as its virtual reality business has continued to bleed cash.

Meta's headcount is down 22% from its peak in the fourth quarter of 2022, according to Market Intelligence. It also open-sourced its artificial intelligence models, giving it an opening to catch up with generative AI market leader OpenAI LLC. In its latest earnings release, the company rewarded shareholders with a $50 billion increase in share buybacks and the launch of a dividend. Combined with better-than-expected results, Meta's stock surged 20% on the news.

This has had a massive impact on its valuation. Meta has seen its TEV/EBITDA ratio increase three-fold since hitting a low in late 2022. It is now higher than Alphabet's.

By contrast, Alphabet's headcount is down just 4.3% from its peak in the first quarter of 2023. Moreover, it has the largest cash stockpile among the Magnificent Seven stocks at about $110 billion, with no clear plan on how it will deploy that cash. Amid the current regulatory environment, M&A seems not to be an option.

"After Meta announced a dividend, there is growing pressure on Alphabet to follow suit," said Juan Pablo Albornoz, an equity and fixed-income senior research analyst at S&P Global. Albornoz expects Alphabet's management to be quizzed about the dividend at the next earnings call.

Historically, Alphabet has preferred to return cash through share buybacks, which, unlike dividends, can be reversed quickly. But that preference could be changing.

"Because Alphabet's recent track record at deploying cash profitably is not very good, investors might value the stock higher if it's being returned to investors via dividends," said Amira Abdulkadir, US head of dividend forecasting at Market Intelligence.