Baidu: Limited Upside, Unlimited Downside

| About: Baidu, Inc. (BIDU)

Baidu, Inc. (BIDU) is a Chinese web services company which operates one of the world’s leading search engines. Beijing-headquartered Baidu, a.k.a. the Google of China, provides an index of more than 750 million web pages, 10 million multimedia files, and 80 million images. The company greatly benefited from Google’s (NASDAQ:GOOG) decision to exit a Chinese market, becoming an almost monopoly with no serious competitor left in the market.

As of August 30, Baidu stock was trading at $148 with a 52-week range of $76.04-165.96. It has a market cap of $51.8 billion. Trailing 12 month P/E ratio is 64,9 and forward P/E ratio is 34.2. P/B, P/S, and P/CF ratios stand at 29.6, 31.4, and 70.4, respectively. The three-year annualized revenue and EPS growth stand at 65.6% and 77.3%, respectively. Operating margin is 52.2% and net profit margin is 46.5%. The company has a low debt-to-equity ratio of 0.02. Baidu does not have a dividend policy.

Baidu has only two star ratings from Morningstar. While its trailing P/E ratio is 64.9, it has a five-year average P/E ratio of 83.1. Although it is a high-flier, out of 35 analysts covering the company, 27 have buy, four have outperform, three have hold, and one has underperform ratings. Wall Street has diverse opinions on Baidu’s future. The bottom line is 27.9% growth, whereas the top-line growth estimate is 84.1%. Average five-year annualized growth forecast estimate is 41.7%.

What is the fair value of Baidu given the forecast estimates? In this article, the 14th in a never-ending series, I will show a step-by-step calculation of Baidu’s fair value using discounted earnings plus equity model.

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.
Baidu’s Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. Since we are in the middle of the year, it will be more feasible to take the average of ttm EPS of $2.20 along with the mean estimate of $4.32 for the next year.
E0 = EPS = ($2.20+ $4.32) / 2 = $3.26
Wall Street holds diversified opinions on Baidu’s future. 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 41.7%. Book value per share is $5.01.
The rest is as follows:

Fair Value Estimator
E0 (1+g)/(1+r)
Fair Value Range
Lower Boundary
Upper Boundary
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 five-year discounted-earnings-plus-book-value model, the fair-value range for Baidu is between $139.7 and $144.71 per share.
As of Aug 30, Baidu was trading at a price of $148 with a 52-week range of $76.04-165.96. I see substantial growth potential in Baidu. However, the market has already priced this potential. The current price of $148 indicates that the stock is overvalued. Based on my FED+ fair value estimate, Baidu is trading almost 10% higher than my fair-value range. There is also a very high possibility that the growth rate might be lower than analyst estimates. Besides it has an extremely high P/B ratio of 29.6.
O – Metrix Confirmation
If the math above looks too complicated for you, try estimating the fair value using the O-Metrix as such:
O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5
· Dividend Yield: Higher is better.
· EPS Growth: Higher is better.
· P/E Ratio: Lower is better.
The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far.
What is the O-Metrix Score?
  • Baidu does not have a dividend policy. Therefore, the yield is 0.
  • Growth estimate is the same as the discounted earnings model and is equal to 41.70%.
  • Since we are at the middle of the year, taking the average of ttm (64.9) and forward (34.2) P/E ratios will smooth the results. Thus, the average P/E ratio to be used in the model is 49.55.
O-Metrix = [(41.70 + 0) / (49.55)] * 5 = 4.21
Depending on the benchmark chosen, the market has an O-Metrix score range between 4 and 5. Baidu's O-Metrix score of 4.21 is on the lower-end of market’s fair-value range. Back-testing of this ranking system shows that companies with higher-than-average O-Metrix scores beat the market with lower volatility. At a price of $148, the company is trading within the C-Grade, average-return zone.
[Click to enlarge]
Baidu’s stock has always been priced at a premium due to its high growth potential. The average P/E ratio in the last five years was 83.1. The stock is trading with a sky-high P/E ratio of 64.9, and a forward P/E ratio of 34.2. In the last five years annualized EPS growth was 132.51%. However, with a market cap of $51.8 billion, I do not expect the growth to keep its pace. Even if it does, this has already been priced by the market.
As of Aug. 30, Baidu was trading at $148 with a 52-week range of $76.04-165.96, higher than my fair-value range of $139.70-144.71. Its price to book ratio of 29.6 is well-above the market. Its trailing price to sales ratio of 31.4 is also above the market. Analysts have very optimistic estimations. However, I think it is a high-risk investment to buy Baidu shares. There is a gap between $110-115 range which has yet to be filled. The stock returned almost 90% in a year. Maybe, it is the time to realize the profits while you can.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.