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