# Valuing Alibaba (9988.HK): Using Discounted FCFE Method for Mature Growth Stocks

## Introduction - Alibaba as a mature growth company

In the world of growth investing, Alibaba is a classic fallen angel. Since its IPO a decade ago, the company has grown by leaps and bounds, with the stock price peaking at 298HK$ in October 2020. Subsequently the company's growth rate has declined, resulting in a steadily declining stock price. It closed at 72.50 HK$ on July 9, 2024 with a market capitalization of 1,411,5 billion HK$.

Due to a combination of factors, including the Covid-19 lockdowns, China crackdown on the Tech industry, and fierce competition from new players, the company's growth rate has declined significantly. The company managed to register single-digit growth in its latest financial year that ended in April 2024, growing its revenue and net profit by 8% and 9% respectively. Despite the more modest growth rate, Alibaba still maintains a dominant position in its core business of e-commerce, with a large and loyal customer base in China. They are leveraging their strength in e-commerce to continue expanding into overseas markets.

Alibaba currently exhibits characteristics of stable growth rate, dominant market position, and an established business model, making it a mature growth stock. It currently returns value to shareholders via a combination of dividends and stock buybacks, while reinvesting retained earnings into continued expansion.

## Valuing mature growth stocks

Valuing a mature growth stock can be difficult, especially if it does not pay significant dividends and instead focuses on stock buybacks. In such cases, the discounted free cash flow to equity (FCFE) method stands out as a particularly effective method for the following reasons:

## Comprehensive Valuation

The FCFE method focuses on the cash flows available to shareholders after the company has paid all of its operating expenses, taxes, debt repayments, and capitalexpenditures. Unlike the dividend discount model, which focuses solely on dividends, the FCFE method considers the total value generated for shareholders, including stock buybacks. This is critical for companies that prioritize buybacks over dividends.

## Reflects real-world financial strategies.

Many mature growth companies use stock buybacks for a variety of strategic reasons, including increasing earnings per share, gaining tax benefits, and signaling confidence in the company's prospects. The FCFE method accurately reflects these real-world financial strategies by including the cash flows used for buybacks, resulting in a more accurate picture of the company's value.

## Considers Growth and Reinvestment Needs.

Mature growth companies must continue to reinvest in their operations to maintain growth. The FCFE method accounts for these reinvestment needs by taking into account capital expenditures and working capital changes. This ensures that the valuation reflects the company's long-term growth potential, rather than its immediate cash returns to shareholders.

## Adapts to Capital Structure Changes.

Stock buybacks frequently cause significant changes to a company's capital structure. Companies may issue new debt or use existing cash reserves to fund buybacks. The FCFE method accounts for these capital structure changes, making it capable of capturing the financial dynamics and actual effects of buybacks on shareholder value.

## Aligns with shareholder value creation.

Shareholders are ultimately interested in the value that a company can provide them, whether through dividends, buybacks, or stock price appreciation. The FCFE method measures the actual cash flows available for these returns, which is closely aligned with the goal of increasing shareholder value. As a result, it is an especially appealing valuation strategy for investors.

## Discounted Free Cash Flow to Equity with constant growth

The discounted free cash flow to equity model (constant growth) is a straight-forward but effective model that estimates the intrinsic value of a stock based on the present value of its future levered free cash flow, which are assumed to grow at a constant rate in perpetuity.

### Equation 1: Estimating intrinsic value of the company from levered free cash flow, investors' required rate of return and constant growth rate in perpetuity.

The formula for the model is as follows:

- P
_{0}= Intrinsic Value of the Company - FCFE
_{1}= Levered Free Cash Flow for next fiscal year - K
_{e}= Discount rate or Required Rate of Return - g = Constant growth rate in perpetuity for FCFE

### Method 2: Estimating the implied rate of return from levered free cash flow, current market capitalization and constant growth rate in perpetuity

By rearranging the formula, we get the following equation that allows us to reasonably estimate the implied rate of return, given the current market capitalization, analyst estimates of next year's FCFE and a reasonable assumption for growth rate:

## Applying the discounted FCFE model with constant growth rate to Alibaba

Simply Wall Street provides an estimate for Alibaba's levered free cash flow for FY 2025 as follows:

For FY 2025, the average of 7 analysts estimate for Alibaba's levered free cash flow is 152.236 billion CNY. In HK$, the levered free cash flow is 163.4 billion HK$. The market capitalization for Alibaba on July 9, 2024 is 1411.5 billion HK$.

- Method 1: Assuming a required rate of return of 12% per annum and a constant growth rate in perpetuity of 2.5%, the intrinsic value of Alibaba is estimated at 1,720 billion HK$. This implies a 22% upside to its market capitalization on July 9, 2024.
- Method 2: Assuming a constant growth rate in perpetuity of 2.5%, and based on its market capitalization on July 9, 2024, the implied rate of return for Alibaba stock is estimated to be 14% per annum. By all measures, that is a reasonably attractive rate of return.

## Conclusion

Alibaba is a mature growth stock with a dominant market position in its e-commerce business in China. Its recent growth rate has matured to high single digit, and it returns value to shareholders via a combination of dividends and stock buybacks.

The FCFE method stands out as an effective tool for valuing mature growth stocks with a stock buyback policy. By focusing on total cash flows available to shareholders, taking into account reinvestment needs, and adapting to capital structure changes, it provides a comprehensive and realistic assessment of a company's intrinsic value. For investors seeking to determine the true value of such companies, the FCFE method provides a straightforward and effective approach.

In this article, the discounted FCFE method is used to estimate the intrinsic value of Alibaba based on a required rate of return of 12% per annum, analyst estimates of next year's FCFE and a reasonable assumption for the growth rate. The intrinsic value of 1,720 billion HK$ implies a 22% upside from its closing price on July 9, 2024.

Alternatively, the implied rate of return is estimated, given its current market capitalization, analyst estimates of next year's FCFE and a reasonable assumption for the growth rate. The implied rate of return for Alibaba stock is estimated to be 14% per annum.