75 Billion Reasons To Own Google

Alphabet (Google’s parent) has significantly ramped up research and development spending in recent years. In 2022, Google spent about $39.5 billion on R&D, which jumped to $45.4 billion in 2023. This ~15% increase was driven largely by higher personnel costs (adding thousands of engineers) and one-time charges like office space consolidation.

R&D now represents roughly 15% of Google’s annual revenue, reflecting heavy investment in areas like artificial intelligence (Google DeepMind, Bard), cloud services, and experimental “Other Bets.” These R&D outlays are expensed each year, directly reducing operating profit in the short term.

So what’s the tradeoff between high spending and profitability? Will Google’s bets pay off?

Key Points

• Google’s R&D rose to $45.4B in 2023, and CapEx hit $32.3B, with $75B planned for 2025, primarily for AI and cloud infrastructure.
• Heavy spending pressures margins and cash flow, but AI-driven products are likely to fuel future growth.
• Success in monetizing AI (ads, cloud, enterprise tools) is set to drive massive returns.

What Is Google Spending Money On?

Google is pouring capital into infrastructure such as data centers, servers, and network equipment to support its services.

Capital expenditures were $31.5 billion in 2022 and ticked up to $32.3 billion in 2023. The bulk of this CapEx was for “technical infrastructure” meaning the compute capacity for Google Search, YouTube, Google Cloud, and emerging AI workloads.

In addition, Google invests in office campuses and other facilities, but the data center and server spend is by far the largest component. Despite broader economic uncertainty, Google maintained a high pace of infrastructure investment through 2022–23 to ensure it can handle growing usage and new AI models.

Over the past few years Google has been steadily increasing both R&D and CapEx in order to fuel future products and capabilities – e.g. better AI-driven search results, cloud AI services, and innovations in Android, hardware, and autonomous tech.

Notably, Google’s R&D in 2023 was $5.9 billion higher than in 2022, a sizable uptick that slightly outpaced revenue growth. Similarly, infrastructure spend in 2023 was up about $800 million from the prior year. This indicates Google’s commitment to long-term growth projects even as it managed costs elsewhere in the form of layoffs and slower hiring in 2023. Such heavy investment ensures Google stays at the forefront of technology, but it can pressure near-term financial metrics as discussed later.

Future Capital Allocation Plans

Over the next few years Google management plans an even more aggressive capital investment approach, especially for AI infrastructure.

In Q4 2024, CEO Sundar Pichai announced that Alphabet “expects to invest approximately $75 billion in capital expenditures in 2025.” which is more than double the year prior’s figure, and making it clear that AI is fully in their crosshairs.

A large portion of this $75B will go into servers, GPUs, data center construction, and network capacity to train and run advanced AI models. In management’s words, they plan to “increase…investment in technical infrastructure…in particular in support of AI products and services.”

This likely includes spending on the chips needed for Google’s own generative AI, like its PaLM and Gemini models, and expanding Google Cloud’s AI offerings.

On the R&D side, while exact forward-looking figures aren’t disclosed, Google is expected to continue elevated R&D spending. The focus will be on artificial intelligence research at Google Brain/DeepMind, improvements to core search and ads, cloud computing advancements, and new “Other Bets” (like self-driving unit Waymo and health-tech) that are forecasted to drive future growth.

Given the 2023 run-rate of $45B in R&D, it would not be surprising if Google’s R&D crosses $50 billion in the next year or two. Any integration of AI into products, for example AI features in Search, YouTube, Workspace, involves substantial ongoing research expense.

In short, future capital allocation will skew heavily toward AI and cloud infrastructure, along with the R&D talent to leverage that infrastructure. Google’s leadership has expressed confidence that these investments will “accelerate our progress” in key areas, even as they carefully monitor ROI.

Financial Impact on Google’s Valuation

Effects on Earnings and Profit Margins

Heavy R&D and infrastructure spending is likely to weigh on Google’s earnings and operating margins in the near term. The nearly $6 billion rise in R&D expense from 2022 to 2023 effectively subtracted that amount from 2023 profit – equivalent to about 7% of Alphabet’s 2023 operating income.

Google’s operating margin was 27% in 2023, a solid figure but lower than it would be if R&D were scaled back (for context, without any R&D expense, margins would be astronomical – but at the cost of future innovation).

Last year, Google operating margins ballooned to 32% as revenue growth and cost controls kicked into high gear. Management is clearly attempting to balance spending and profitability, and in that vein, has cut costs, such as headcount and office space in order to offset margin pressure from rising R&D.

Infrastructure spending impacts earnings more indirectly through depreciation. Google depreciates data center assets over several years, so the $32B of CapEx in 2023 will flow through the income statement gradually.

Depreciation on property and equipment was about $11.9B a couple of years ago. As Google doubles down on CapEx for AI, depreciation expense will climb, creating a drag on future operating margins.

Morningstar analysts expect Alphabet’s operating margins to stay roughly flat around low-30% levels over the next five years as hefty depreciation from new AI infrastructure offsets some efficiency gains.

The bottom line is big R&D outlays and CapEx mean Google is not going to maximize short-term earnings. The tension is that if these investments don’t translate into higher revenue or new income streams, they simply dilute margins.

Every additional point of revenue growth driven by AI or other R&D can justify the margin hit; conversely, if spending outpaces revenue gains, operating margin will contract, potentially hurting earnings growth and valuation multiples.

Impact on Free Cash Flow and DCF Valuation

Free cash flow is arguably the most directly affected by infrastructure spending.

FCF is operating cash flow minus capital expenditures. A couple of years ago, Alphabet generated $101.7B in operating cash flow, but after $32.3B in CapEx, FCF was about $69–70B (roughly flat from the prior year).

All else equal, every extra dollar of CapEx is a dollar less in current free cash flow. For a discounted cash flow valuation, heavy near-term investment can reduce the present value because it lowers cash flows in the immediate years.

So, if Google follows through on, say, an incremental $40B jump in CapEx in 2025 (from ~$35B toward $75B), that $40B is cash not available to shareholders in that year.

At a 10% discount rate, a one-time $40B drop in FCF might well trim roughly $36B from the DCF present value (roughly ~3% of Alphabet’s ~$1.5 trillion market cap).

The billion dollar question is what Google earns on those $40B of investments in the future and whether they will enable new services or revenue streams, such as better AI features that keep users engaged, or new AI subscription services, it will boost future cash flows and the terminal value in a DCF model.

Investors are left with the conundrum to weigh short-term FCF compression versus long-term growth. Google’s management clearly believes these investments will yield high returns and cite opportunities in AI and continued core business growth.

If the $75B AI infrastructure push leads to even a modest few percentage points of incremental annual revenue growth (say, Search ads enhanced by AI, or new AI subscription services), that will translate to tens of billions in extra revenue and several billion in extra profit annually within a few years.

Capitalized in a DCF or earnings multiple, that upside could add on the order of $50–100B+ to Alphabet’s valuation equating to a mid-single-digit percentage increase.

What Does It Mean For Google Investors?

Google’s heavy R&D and CapEx spending will impact near-term profitability but could significantly enhance long-term value if AI and cloud investments yield strong returns.

The looming question is whether Google will in fact monetize AI and grow revenue persistently, and if management’s bet pays off the valuation impact will be positive. If not, high spending without revenue upside could weigh on Alphabet’s margins and free cash flow, limiting upside.

The next 1–3 years will be crucial in determining whether these investments truly move the valuation needle.