Alibaba (NYSE:BABA) stock has had a rough year, and had actually fallen 1.7% to $228.64 on April 20 from its 2020 year-end close of $232.75. In fact, over the last year, BABA stock is up just a bit over 10%. That is nothing to write home about. But the truth is the stock is now very cheap, and likely to do much better over the next year.
This is especially true now that the Chinese e-commerce conglomerate, with a similar business model to Amazon (NASDAQ:AMZN), has weathered a lengthy review from Chinese regulators. On April 10, they accepted a $2.8 billion antitrust fine from the State Administration for Market Regulation (SAMR) in the PRC. This is effectively a slap on the wrist, as the fine represents just 4% of its 2019 revenue.
Analysts were uniform in arguing that this is a relief for BABA stock. One analyst from HSBC pointed out that this would not affect its gross merchandise value (GMV). Apparently what riled regulators were actions from one of Alibaba’s “Tmall flagship stores that are directly operated by brands.” The point is its fundamental business model won’t be changed or affected.
Comparing Alibaba’s Valuation
In my previous article at the end of last year, I compared the valuation of Alibaba stock to Amazon. I found that Alibaba was very cheap, as its price-to-earnings (P/E) ratio was one-third that of Amazon. This was the case even though both had similar price-to-sales ratios.
Well, the same is true today. For example, BABA stock has a forward P/E ratio (for 2021) of 22 times earnings (year ending March) and just 21 times for 2022, according to Seeking Alpha. Compare this to AMZN stock. Its 2021 forward 2021 P/E multiple (year ending December) is 70 times, and for 2022 is 50 times earnings. This means that Alibaba trades for under a third of the 2021 AMZN stock ratio and 42% of the 2022 ratio.
Moreover, Alibaba has similar, if not better, free cash flow (FCF) margins as compared to Amazon. For example, according to Seeking Alpha, during the last 12 months (LTM) ending in December 2020, Alibaba generated $27.148.02 billion on $98.686 billion, or a 27.5% FCF margin. But Amazon had $31.02 billion in FCF on $386.06 billion in revenue, or an 8% FCF margin. In other words, Alibaba has 3.4 times the FCF margins of Amazon.
What Alibaba Is Worth
So the Alibaba valuation is out of whack. Granted, Alibaba operates out of a non-democratic, one-party state where regulators appear to be punishing the company’s founder, Jack Ma. Theoretically, Alibaba could get whacked again at the whims of the Communist Party in China just because they want to crack down on independent thinking billionaires.
So Alibaba stock deserves a discount. The stock valuation has to have a huge discount as its fortunes could be decimated by a one-party state government. This has happened numerous times in the past in similar countries, like Russia. Moreover, the State regulator SAMR could always come back with a much more severe fine — or even confiscation of ownership.
But maybe a 66% discount to the valuation is too much (i.e., the 2021 P/E valuation discount). For example, let’s assume there is just a 50% discount to the comparable 2021 P/E value (to account for the PRC discount) and a 40% discount to the 2022 valuation. That would give BABA stock a P/E ratio of 35 times for 2021 (i.e., 50% x 70 multiple) and a 30 times ratio for 2022 (i.e., 60% x 50 times).
As a result, the implied discounted 2021 valuation is$356.65 (i.e., $10.19 EPS for 2021 times 35 P/E) and $335.70 for 2022 (i.e., $11.19 2022 EPS x 30 P/E ratio). The average of these two target prices is $345.88 is still 50% above today’s price (April 20).
So, even after discounting Alibaba’s prospects by 50% for 2021 and 40% for 2022 (assuming the regulatory crackdown abates by then), the stock is still very cheap.
What to Do With BABA Stock
Many analysts fail to properly discount Alibaba’s valuation. They see the discrepancy with Amazon and other Western tech stocks and say this stock is worth three times more.
The problem is that the Chinese authorities are controlled by a Communist ethos, which, at its core, is fundamentally opposed to capitalism. Moreover, in this particular case, there is no doubt that the authorities have been pursuing Jack Ma’s related companies, including Ant Financial.
No one really knows where any of this regulatory scrutiny could end. It is a massive, volatile, uncertain, and potentially totally destructive risk for owners of BABA stock. The market is not blind to this risk, which is why the stock is so cheap. However, I do believe that the market has overdone the risk discounting. It seems likely now that the stock will rise assuming that the government scrutiny is over.
This could be a wild ride. Keep in mind that BABA stock carries huge risks, despite its massive profitability. Nevertheless, right now it looks like the stock is worth about 50% more, or $345.88 per share.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.