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By Ahmed Ishtiaq

Baidu Inc (NASDAQ:BIDU) is a leading Chinese-language Internet search engine, with about 80% of the search market in China. The company offers news, MP3, video, and image search. It earns nearly all of its revenues through online advertising services. In order to reap the rewards of a market that consists of a whopping 470 million Internet users, the company has had to accept a massive government bureaucracy and its censorship rules. Baidu also operates in the Japanese market through Japanese-language search service Baidu Japan.

As of the time of writing this article, Baidu stock was trading at around $92.56, with a 52-week range of $85.96 - $154.15. It has a market cap of about $32.4 billion. The trailing twelve-month P/E ratio of 20.3 is below the forward P/E ratio of 14.6. P/B, P/S, and P/CF ratios stand at 8.7, 9.9 and 16.1, respectively. The operating margin is 51.4% while the net profit margin is 47.5%. The company has a low debt load, with a debt/equity ratio of 0.1.

Baidu has a 4-star rating from Morningstar. Out of 10 analysts covering the stock, four have a buy recommendation and one has sell recommendation. On the other hand, most of the analysts have market outperform rating, and two analysts have hold recommendations for the stock. Average five-year annualized earnings growth forecast estimate is 29.10%.

We can estimate Baidu's fair value using the discounted earnings plus equity model as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Baidu is $4.80.

While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 29.10%. Book value per share is $7.44.

Fair Value Estimator

V0

E0

$4.82

V1

E0 (1+g)/(1+r)

$5.61

V2

E0((1+g)/(1+r))2

$6.52

V3

E0((1+g)/(1+r))3

$7.58

V4

E0((1+g)/(1+r))4

$8.82

V5

E0((1+g)/(1+r))5

$10.26

D

E0(1+g)5/[r(1+r)5]

$93.25

BV

Equals

$7.44

Fair Value Range

Lower Boundary

$136.86

Upper Boundary

$144.30

Potential

55.90%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Baidu is between $136.86 and $144.30 per share. At a price of about $92.56, Baidu is trading below the lower boundary of its fair value range. The stock still has up to 56% upside potential to reach its fair value maximum.

Summary

Baidu is the dominant search engine in China, and it should benefit from its market position. Advertisers are currently allocating more funds to search advertising due to its efficiency and measurable results. At the moment, small and medium businesses are adopting paid search, which should help Baidu grow as it is the main target market for the company. Our model shows that if the company is able to maintain current growth rate then it will prove to be a solid investment. The stock is trading below its fair value at the moment, and there is a substantial potential for capital gains.

Source: Baidu Has Substantial Upside Potential