Shares of Alibaba Group Holding Ltd. could be worth $220 a piece. Long term Investors should buy into this dip in Alibaba stock price.
Shares of Hangzhou, China based Alibaba Group Holding Ltd. (NYSE:BABA) have retreated from their recent all time highs. Alibaba stock price closed the last trading session at $168.3 a piece, down from a peak of $177, which it hit only a couple of trading sessions ago. With the share price dropping by 4.2% in the last 3 trading sessions, is this an opportunity to buy Alibaba shares on the cheap? Or, up 91.7% this year, is it time to take some money off the table and sell Alibaba stock? We believe it's a case of the former, and here is why.
Alibaba Stock Riding Multiple Macro Tailwinds
The e-commerce segment contributed over 85% of revenue in the latest quarter and is at the heart of the spectacular growth Alibaba is generating. Alibaba revenue is up from $977.8 million in 2010, to $22.99 billion in FY 2017 (March 2017 ending), translating to a CAGR (compounded annual growth rate) of nearly 57% over the last 7 years.
Coming to the bottom line, Alibaba Net Income has grown from $176.6 million in FY 2011 to $6.35 billion FY 2017, growing at an average annual rate of over 80% over the six-year time frame.
A clarification is due at this stage. The above chart can mislead readers/investors to believe that Alibaba earnings declined in the most recent year. However, this was due to impact from exceptional items in FY 2016, which boosted Net Income by nearly 50%. Adjusting for the one-time gains, Alibaba's revenue/earnings growth has been consistently strong over the last 7 years. And well, this spectacular growth isn't about to end anytime soon.
The e-commerce market makes up only 15% of the total retail market in China. As the growing middle-income population in China continues to shift more of their offline shopping to online channels, Alibaba will be the key beneficiary. But, Alibaba isn't happy just riding on this trend alone. The company recently outlined a strategy to take a share of the offline retail market, which at $4.25 trillion, is a massive opportunity. As we have outlined in our recent Alibaba coverage, driven by favorable macro trends and armed with an effective execution strategy, Alibaba stock makes for a solid long term buy. So, how much do we believe Alibaba stock is worth? Let's get down to the numbers.
Alibaba Stock Valuation
Alibaba stock currently trades at seemingly expensive valuations. Based on the closing price (August 28), Alibaba stock was quoting at 56.8x its TTM (Trailing Twelve Month) earnings, which isn't cheap. However, investors are valuing Alibaba for future growth and hence it's pertinent to evaluate the company on a forward basis.
Wall Street consensus currently expects Alibaba to report FY 2019 EPS of $6.48 a share. Valuing Alibaba on a forward basis, the stock currently trades at nearly 26x the FY2019 EPS estimate, which is a steep discount to the average earnings multiple the stock has commanded over the last 5 years. The valuation range of Alibaba stock over the last 5 years is summarized in the table below.
The 26x forward multiple that Alibaba stock currently trades at is a 23.5% discount to the 5-year average multiple, offering investors a fair amount of safety, especially when you consider the growth the company is delivering. Valuing Alibaba at its average 5 year PE multiple, Alibaba stock could be worth $220, implying an upside of over 31% to the last closing price. Talking about growth, let's now factor that into our Alibaba stock valuation.
Alibaba reported EPS of $3.52 a share in FY 2017. Based on the current FY 2019 estimate, Wall Street expects Alibaba earnings to grow at an average annual rate of approximately 36% over the next two years. We now use the PEG ratio (Price/earnings to growth ratio) to value Alibaba stock. As explained by Investopedia, a PEG ratio of less than 1 is desirable. Using a forward PEG ratio of 1 and expected earnings growth of 36% (calculated earlier for FY 2017-FY2019), we can assign Alibaba stock a multiple of 36X the FY 2019 estimate. And, how does that look? At 36X the FY 2019 EPS estimates, Alibaba stock should be worth $233.3 a piece, good for a 38.6% upside from the last closing price.
To sum up, Alibaba stock is riding multiple macro tailwinds, which, in combination with an effective management team and a clear strategy should help the company maintain the strong growth in its fundamentals. In light of this, it isn't hard to see why MKM Partners recently picked out Alibaba as the best mega-cap technology stock. we believe that Alibaba stock could be worth anywhere between $220 to $233 a share, and, at the current price levels, is a strong buy offering a solid upside potential for long term investors.
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