Estimating the Intrinsic Value, Return on Investment and Margin of Safety of Alibaba based on Discounted Earnings Model.

Summary

This article looks at the valuation of Alibaba shares trading on the Stock Exchange of Hong Kong (Ticker: BABA-SW (9988.HK). The Discounted Earnings Model is used to estimate the share's Intrinsic Value, Expected Return on Investment, and its Margin of Safety.

Introduction

The past year has been a tumultuous one for Alibaba. Starting with the suspension of Ant Financial's 37 billion US$ IPO in November 2020, the company has just been hit with one bad news after another. In April this year, China's Antitrust Regulator slapped Alibaba with a record breaking fine of 18.4 billion RMB for abusing its monopoly position in the e-commerce industry. In recent days, there have been reports that the Chinese Government is considering breaking up Ant Financial's Alipay online payment app and splitting the loan business into a separate app.All the bad news has culminated in the sharp decline of Alibaba's share price, which has fallen 48% from its 52 week high of 309.40HK$.

Such a massive correction in one of the best e-commerce companies in the world has certainly attracted the attention of many in the investment community. Legendary value investors Charlie Munger and Monish Pabrai have reportedly invested in Alibaba shares earlier this year. The time is right to have a closer look at the current valuation of Alibaba shares trading on the Stock Exchange of Hong Kong. Discounted Earnings Model is one of many methods for valuing stocks. The procedure is similar to the Discounted Cash Flow model, with the free cash flow being substituted with earnings or net income. One advantage of using this method is that earnings data are easily available from the company's financial reports.
This article describes the use of the Discounted Earnings Model to determine the Intrinsic Value, Expected Return on Investment, and Margin of Safety of Alibaba shares trading on the Stock Exchange of Hong Kong (Ticker: BABA-SW (9988.HK).

Alibaba Earnings History 2016 to 2021

Tabulated below is Alibaba's earnings history for Fiscal Years 2016 to 2021. The information is obtained from the Alibaba Annual Financial Reports.

A few important points to note here:From FY2016 to FY2021:

1. 1. Revenue increased at a compounded annual growth rate (CAGR) of 47.96%

1. 1. Net Income or Earnings increased at a compounded annual growth rate (CAGR) of 16.03%

1. 1. Earnings per share grew at a compounded annual growth rate (CAGR) of 14.41%

1. 1. Average Net Income Margin from FY2016 to FY2021 = 32.88%

There is no denying that historical financial performance have shown Alibaba to be a growth company. However, what is important, going forward, is the future growth potential of the company. As they say, past performance is not indicative of future performance.

10 year Discounted Earnings Model for Alibaba

In order to evaluate the investment worthiness of Alibaba going forward, a cash flow analysis is used to determine a reasonable estimate of the Intrinsic Value, Expected Return on Investment and Margin of Safety of Alibaba shares. The Discounted Earnings Model is adopted for this purpose. Key parameters for the Discounted Earnings Model are as follows:

• • Beta = 1.0

• • Market Risk Premium = 10.5% (Based on Market Risk Premia data for Hong Kong, November 2021)

• • Risk Free Rate = 0.94% (Based on Market Risk Premia data for Hong Kong, July 2021)

• • Expected Return on Capital Asset, Ke = 0.94% + 1.0 x 10.5% = 11.44%

• • Time period = 10 years (From Fiscal Year 2022 to 2031)

• • Annual Revenue Growth Rate is modelled to decline from 40.72% in FY2021 to 10.52% in FY 2031. This is a conservative assumption taking into account that from FY2016 to FY2021, Alibaba's Annual Revenue grew at a Compounded Annual Growth Rate of 47.96%.

• • Net Income Margin is modelled to decline from 21.0% in FY2021 to 15.1% in FY 2031. This is a conservative assumption taking into account that from FY2016 to FY2021, Alibaba's Net Income Margin averaged 32.88%.

• • Earnings in FY2032 is modelled to grow an additional 10% from FY 2031.

• • FY2032 Earnings is used to forecast the future stock price in FY2031 using the equation below:

• • Sustainable growth rate to perpetuity beyond FY2032 = 3.5%.

• • Quantity of ordinary shares (fully diluted) = 22,000 million.

• • Currency exchange rate = 1.2HK$/RMB

The 10 year Discounted Earnings Model is as shown below:

With reference to the summary table above, the following can be noted :

1. 1. Based on a discount rate of 11.44%, the intrinsic value of the share is estimated at 226.93HK$ per share. The margin of safety is 29.14% based on the closing price of 160.80HK$ on 13th September 2021.

1. 1. Based on a discount rate of 12.00%, a personal hurdle rate,  the intrinsic value of the share is estimated at 209.66HK$ per share. The margin of safety is 23.31% based on the closing price of 160.80HK$ on 13th September 2021.

1. 1. Using the goal seek function of Excel, the discount rate which will yield an intrinsic value of 160.80HK$ is calculated to be 14.15%. This value of 14.15% is the Expected Return on Investment for Alibaba shares at a cost basis of 160.80HK$ per share, over a 10 year period.

Conclusion

In this article, I set out to document the rationale behind an investment decision to purchase the Alibaba shares trading on the Stock Exchange of Hong Kong. Based on my personal hurdle rate of 12.0%, the Intrinsic Value of Alibaba is estimated to be 209.66HK$ providing a reasonable margin of safety of 23.31%. Additionally, at a purchase price of 160.80HK$ per share, the Expected Return on Investment is estimated to be an attractive 14.15% per annum.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.