Seeking Alpha

Alibaba's Undervaluation Has Reached A Critical Point - Part 2

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About: Alibaba Group Holding Limited (BABA)
by: Oleh Kombaiev
Oleh Kombaiev
Commodities, internet, medium-term horizon, ETF investing
Summary

The pessimistic scenario assumes that Alibaba's revenue CAGR won't exceed 16% in the coming 10 years.

We also can assume that Alibaba's operating margin will drop from the current 18% to 11%.

But even based on these key assumptions, the DCF model clearly indicates a growth potential of Alibaba’s shares.

In my last article dedicated to Alibaba Group (BABA), I stated that the company is critically undervalued mainly because of the trade war between the U.S. and China. Today, I want to check my conclusions by building a DCF model. Or, actually, three models...

I considered three scenarios: baseline, pessimistic and highly optimistic.

1. Baseline scenario

To forecast Alibaba's revenue for the next decade, I used a polynomial model that most closely matches the revenue dynamics of the company over the past five years and the current average estimates of analysts:

So, I assume that the Compound Annual Growth Rate (CAGR) of BABA’s revenue in the next 10 years will amount to 17%:

Alibaba DCF revenue forecast

Moving onto the WACC:

I used the current yield of the China 10-year bond as a risk-free rate, equity risk premium of 6.94% and one-year rolling beta coefficient. I suggest that in the future, the beta coefficient will decrease to the average, which would entail lowering of the WACC.

Alibaba Group Beta coefficient

The baseline scenario assumes a gradual decrease in Alibaba's operating margin from the current 18% to 14% in a terminal year due to increased competition and the active development of the company in its non-core segments:

ChartData by YCharts

The relative size of CAPEX will increase from the current 13.3% to almost 16%:

ChartData by YCharts

The tax rate is assumed to be 28%, which corresponds to the average of BABA’s indicator over the previous 5 years:

So, here's the model itself:

DCF model for Alibaba Group

In this case, the DCF-based target price of BABA's shares is $357 (~80% upside).

2. Pessimistic scenario

  • The pessimistic scenario assumes that the company's revenue will grow moderately and the CAGR will reach 15.7% in the next 10 years:

  • Alibaba's operating margin will drop from the current 18% to 11% in a terminal year.
  • The relative size of CAPEX will increase from 13.3% to 18%.
  • The tax rate is assumed to be 30%.

Here is the model:

DCF Alibaba Group Model

The DCF-based target price of BABA's shares is $291 (47% upside).

3. Optimistic scenario

  • The optimistic scenario assumes that the CAGR of Alibaba's revenue in the next decade will amount to 18.3%:

  • Alibaba's operating margin for the next 10 years will slightly reduce to 16%.
  • This scenario involves a gradual increase in the relative size of CAPEX from 13.3% in 2019 to 14.8% in a terminal year:
  • The tax rate is assumed to be 25%, which is the world's average.

Here's the model itself:

In this case, the DCF-based target price of BABA's shares is $423 (113% upside).

Bottom line

In my opinion, a company deserves a recommendation to buy if the DCF analysis conducted based on conservative forecast parameters demonstrates a growth potential of at least 30%. In our case, the pessimistic scenario offers 47% upside. So, it remains to repeat my conclusion from the previous article - Alibaba is critically undervalued.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I don't have a trade position regarding BABA. And I believe that to be an advantage in terms of analysis because I am able to consider indicators impartially without subliminal motivation to see positive or negative sides even if they don't exist