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Baidu's (NASDAQ:BIDU) valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers. Let's dig into our thesis on the valuation of the firm in this article.

But first a little background on some of the technical research jargon. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Our process is simple: we think more interest leads to more buying, which leads to a higher stock price (a greater chance for price-to-fair value convergence).

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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Baidu posts a VBI score of 6 on our scale, reflecting our "undervalued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. We compare Baidu to peers Facebook (NASDAQ:FB), Google (NASDAQ:GOOG), and Yahoo (NASDAQ:YHOO).

Our Report on Baidu

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Investment Considerations

Investment Highlights

• Baidu earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 227.4% during the past three years.

• Baidu's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.

• Baidu has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 36.6% in coming years. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 31.4%.

• The firm's PEG ratio is not only below 1, but it also falls below the median of its peer group. This provides additional support for the firm's attractive valuation on a DCF basis.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Baidu's 3-year historical return on invested capital (without goodwill) is 227.4%, which is above the estimate of its cost of capital of 11.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Baidu's free cash flow margin has averaged about 43.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Baidu, cash flow from operations increased about 169% from levels registered two years ago, while capital expenditures expanded about 178% over the same time period.

Valuation Analysis

We think Baidu's shares are very cheap. Our discounted cash flow model indicates that Baidu's shares are worth between $108.00-$200.00 each, a range that's above where it's currently trading. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $154 per share represents a price-to-earnings (P/E) ratio of about 32.2 times last year's earnings and an implied EV/EBITDA multiple of about 25.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 23.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 76.4%. Our model reflects a 5-year projected average operating margin of 43.4%, which is below Baidu's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 7.1% for the next 15 years and 3% in perpetuity. For Baidu, we use a 11.4% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $154 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Baidu. We think the firm is attractive below $108 per share (the green line), but quite expensive above $200 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Baidu's fair value at this point in time to be about $154 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of Baidu's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $215 per share in Year 3 represents our existing fair value per share of $154 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Why Baidu Is One Of The Cheapest Stocks On The Market