Alibaba Is Undervalued

About: Alibaba Group Holding Limited (BABA)
by: Andres Cardenal, CFA

Alibaba stock is under selling pressure due to the trade war concerns and economic uncertainty in China.

However, the numbers show that Alibaba is still growing at full speed in spite of the challenging environment.

The stock is deeply undervalued based on valuation ratios, discounted cash flows, and multi-factor analysis.

For investors who can handle the short-term uncertainty, Alibaba stock looks like a buying opportunity over the long term.

Alibaba (BABA) stock is under heavy pressure in the past several months. Shares of the Chinese internet giant are down by over 22% in the past year due to investor concerns about the trade war and its potential impact on Alibaba. However, the market seems to be overreacting to this uncertainty, and Alibaba stock looks like a bargain at current prices.

The Business Remains Solid

The economy in China has been quite volatile recently, and the trade war is not helping at all. But Alibaba is a market leader in high growth segments such as online commerce, cloud computing infrastructure, digital payments, and online entertainment, among several other areas with promising potential.

Even in times of increased economic uncertainty, these businesses are firing on all cylinders judging by the company's financial reports. The company reported both earnings and sales numbers above expectations last quarter, and the numbers show that the business keeps growing at full speed.

  • Revenue was RMB376,844 million during the fiscal year ended in March of 2019, an increase of 51% year-over-year. Excluding the effects of consolidating acquired businesses, revenue would have increased by 39% year-over-year.
  • Annual active consumers on Alibaba's China retail marketplaces reached 654 million, an increase of 102 million from the 12-month period ended March 31, 2018.
  • Mobile monthly active users reached 721 million in March 2019, an increase of 104 million over March 2018.
  • Gross merchandise value was RMB5,727 billion for the fiscal year 2019, representing a year-over-year increase of 19%.

Looking at the company's multiple growth engines, Alibaba is enjoying strong performance across the board. This bodes well in terms of evaluating the company's ability to sustain its vigorous growth rates over the long term.

Source: Alibaba Investors Relations

Cheaper Than Ever

As a company matures over time, chances are that growth rates will tend to slow down since it's obviously much harder to sustain rapid revenue growth from a bigger revenue base. However, Alibaba is still generating outstanding performance, and the company has a lot of room to continue growing rapidly if management plays its cards well.

In spite of this, key valuation metrics such as price to earnings, price to sales, enterprise value to EBITDA, and price to free cash flow have significantly contracted in recent years.

Chart Data by YCharts

The trade war can have a negative impact on investors' perceptions and hence on stock prices in the short term. But Alibaba's fundamentals remain stronger than ever, and the stock is attractively valued by historical standards.

Forward-Looking Valuation Metrics

Wall Street analysts are on average expecting Alibaba to make $6.69 in earnings per share during the current fiscal year, meaning the year ended in March of 2020. For next fiscal year, analysts are currently expecting $8.69 in earnings per share from Alibaba.

Under these assumptions, the stock is trading at forward price to earnings ratios of 23.9 and 18.4 respectively. Those valuation levels are hardly excessive for such a powerful growth business with plenty of potential for expansion in the years ahead.

Perhaps more important, valuation is a dynamic as opposed to a static concept. Current stock prices are reflecting a particular set of expectations about the future of the business; if expected earnings increase, then the stock price needs to increase for valuation to remain constant.

We can see how the stock price and earnings per share expectations generally go together over time. However, in recent months, earnings estimates have increased while the stock price has been declining due to the trade war concerns. This is arguably creating an opportunity for value-hunting investors in Alibaba stock.

Chart Data by YCharts

The price to sales ratio for Alibaba has significantly declined over recent months, and the stock is currently trading at a record low price to sales ratio of 7.6. This number looks remarkably attractive by historical standards and even more compelling on a forward-looking basis.

Chart Data by YCharts

Analysts are currently expecting $73.29 billion in revenue during fiscal 2020 and $95.9 billion in fiscal 2021. This puts the forward price to sales ratio for Alibaba at 5.68 and 4.34 respectively. The number represents a huge valuation discount for a company that used to have a price to sales ratio well into the double digits in times before the trade war.

Discounted Cash Flows

The discounted cash flow valuation is based on the following assumptions:

  • Current sustainable free cash flow is RMB105 billion, roughly in line with RMB104.5 billion for the fiscal year ended in March of 2019.
  • The year over year growth rate in free cash flow is 20% for the coming five years.
  • Free cash flow growth slows down to 13% for the five years period after that.
  • The long-term growth rate is 4%
  • The required rate of return is 11%

Under these assumptions, we reach a fair value estimate of $222 for Alibaba, this represents a discount of nearly 35% versus the current stock price.

Sum of Present Value of Cash flows (Millions) RMB 1,485,568
Perpetuity Value of Final Cash flow (Millions) RMB 2,518,797
Equity Value (Millions) RMB 577,847
Implied Share Price $221.95
Discount/Premium to Current Price 35%

This valuation exercise is by no means intended to accurately forecast long-term free cash flow generation for Alibaba since those kinds of long-term forecasts necessarily carry a high margin of error. As opposed to that, the main point is evaluating if the stock is reasonably valued or not based on conservative assumptions for free cash flow generation.

In this particular case and even making fairly safe assumptions about free cash flow, Alibaba stock looks conveniently priced at current levels.

Multi-Factor Analysis

Valuation needs to be analyzed in its due context. A company with strong financial performance and accelerating momentum obviously deserves a higher valuation than a business producing mediocre performance and declining momentum.

This is beyond discussion, but sometimes it can be challenging to incorporate the multiple factors into the analysis in order to see the complete picture from a quantitative perspective.

The PowerFactors system is a quantitative investing system available to members in "The Data Driven Investor." This system basically ranks companies in a particular universe according to a combination of factors such as financial quality, valuation, fundamental momentum, and relative strength. The backtested performance numbers show that companies with high PowerFactors rankings tend to deliver superior returns over the long term.

Data from S&P Global via Portfolio123

Alibaba has a PowerFactors ranking of 88.9 as of the time of this writing, this puts the company deep into the top quartile among stocks listed on the US stock market based on the PowerFactors ranking.

In plain English, this is indicating that Alibaba is attractively valued when considering financial quality, valuation, fundamental momentum, and relative strength together.

The Bottom Line

The trade war is a very real risk factor to consider. The impact on Alibaba's business model should not be too large, but the indirect impact of economic jitters in China could affect investor sentiment towards the company. Besides, since the company makes most of its money in RMB, a depreciating Chinese currency would reduce the value of those earnings when translated to US dollars.

In addition to this, regulatory risk is always a big consideration in China. Besides, Alibaba is significantly expanding through acquisitions, these acquisitions always carry significant integration risks, and they make financial performance more unstable and hard to predict.

However, the main point is that those risk factors are already well incorporated into valuation levels. For investors who can tolerate the short-term uncertainty in Alibaba stock, the current entry price looks like a compelling opportunity over the long term.

Disclosure: I am/we are long BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.