Why you should stay away from Alibaba

Alibaba To Kick Off IPO In U.S.
HANGZHOU, CHINA - MARCH 29: A general view of the Alibaba Group headquarters on March 29, 2014 in Hangzhou, China. Chinese e-commerce giant Alibaba has decided to begin its initial public offering (IPO) process in the United States, the company announced recently. Alibaba Group Holding Ltd began in 1999 with the web site Alibaba.com. It's a privately owned China's Hangzhou-based group of Internet-based e-commerce businesses including business-to-business online web portals, online retail and payment services, a shopping search engine and data-centric cloud computing services. (Photo by Hong Wu/Getty Images)
Photograph by Hong Wu—Getty Images

Alibaba’s most recent IPO prospectus is brimming with fantastic numbers illustrating its power in one of the great markets of the future: Internet commerce in China.

In the first few pages, we learn that Alibaba boasts 279 million online customers who spend almost $300 billion a year on appliances, PCs, groceries and just about everything else. Keep reading and you’ll see that 6 billion packages arrive at its customers’ doorsteps each year. Looking for growth? Alibaba’s mobile sales expanded over 100% last year. It’s not just a market leader, its practically the whole market—a powerhouse that handles an incredible 86% of the online retail sales in China.

Those fabulous statistics, the filing announces, make Alibaba the largest online and mobile commerce purveyor in the world. That means bigger than Amazon, bigger than eBay and, with those growth rates, destined to expand its lead for years to come.

Investors, however, shouldn’t be swayed by those gargantuan figures, awesome though they may sound. They should look at another set of numbers that appear far less appealing, the scary rate at which Alibaba needs to grow earnings in order to deliver a decent return. Examining Alibaba’s fundamentals will be crucial for folks who are tempted to purchase its shares. The company is expected to debut on September 19 in the most celebrated IPO in years—and possibly the biggest tech offering in history. Analysts and pundits are already touting the NYSE newcomer as another Google or Facebook, a matchless growth story you won’t want to miss.

So should you buy Alibaba? Unless your broker has set you up with a pre-IPO allocation of shares, the answer is no.

Alibaba is already a big company, and yet its target share price is so gigantic that it needs to grow like a crazy startup to deliver even ho-hum returns. Unlike its mythical namesake in the Arabian Nights who uttered “Open Sesame!” and collected bags of gold coins, this Alibaba is more likely to deliver a bag of sand than the treasure so many Wall Street mavens are expecting.

Let’s look at the price you’ll have to pay for the shares, and then analyze whether they’re possibly worth it. Alibaba and its bankers state that the offering will be priced at somewhere between $60 and $66 a share, with the exact number to be set the day before trading begins. It’s likely that the shares will jump as soon as they start trading, since demand for the offering is robust. But to keep our assumptions conservative, we’ll predict that the shares stay AT around $66 in the days after the IPO. That would give Alibaba a market cap of $163 billion.

The crucial questions: by how much will Alibaba’s already huge starting valuation need to grow in the future, and are the earnings required to propel it to those levels possible, or simply a fantasy?

We’ll start with the return you’d need to make the stock an attractive buy. You’ll want annual gains of, say, 10% to compensate for the risk of owning these highly speculative shares—and even that number may be too low. Alibaba is unlikely to pay dividends, so in 10 years its share price would need to reach $171 to deliver a 10% annual return. To estimate its market cap in 2024, we’ll need to make some assumptions about how many shares will be outstanding.

It’s clear from the IPO prospectus that Alibaba plans to use its shares as currency for numerous acquisitions. On page 133, management states that it plans to expand via acquisitions and investments in cloud computing, digital media, mobile commerce, logistics, and brick-and-mortar stores. Since April 2014—over just 6 months—Alibaba has spent or committed to spend $8.2 billion on a dizzying series of acquisitions and investments. They include full acquisitions of, or investments in, mobile providers, chain stores, an Internet TV company, a maker of electrical appliances, and a tracking system for medical products. The list goes on to encompass a movie producer, a digital broadcaster, and a Chinese professional soccer team.

So it’s reasonable to forecast that Alibaba will issue plenty of new shares to fund its ambitious plans for expansion. Once again, we’ll be conservative and predict that in 10 years, the share count is just 30% higher than today, meaning Alibaba would issue 740 million new shares at a current value of $50 billion. By 2024, its shares outstanding would stand at 3.2 billion. So to deliver that 10% return, Alibaba would need a market cap of $547 billion, calculated by multiplying the $171 share price times the 3.2 billion shares.

Using that number, we can make a reasonable guess at what its earnings would need to be. For the fiscal year ended March 31, Alibaba posted $3.7 billion in profits. (Its P/E, at $66, would be a formidable 44.) Let’s assume that its P/E falls in 10 years to a number that still exceeds the market’s long-term average, to around 20. In that case, Alibaba would need $27 billion in net profits to provide a 10% annual return.

Getting from $3.7 billion to $27 billion in profits would require an annual growth rate of 20%. It’s possible, but it’s highly improbable. Other than government-owned Fannie Mae and Freddie Mac, only two companies on the Fortune 500 achieved profits over $27 billion in 2013, Exxon Mobil and Apple. With a half-a-trillion-dollar-plus market cap, Alibaba would rank among the world’s most valuable companies. Today, only Apple boasts a valuation over $500 billion. In other words, don’t bet on it.

And this is the best case scenario! Let’s predict what’s highly possible, that Alibaba’s shares pop by, say, 25% on the first day of trading. In that case, Alibaba would need a market cap of almost $700 billion and earnings of $35 billion by 2024 to generate a 10% return for investors. The Chinese online market has a great future, and Alibaba could very well continue on its path to success. But that’s not enough—in fact, not nearly enough—to make it a good investment.

Subscribe to Well Adjusted, our newsletter full of simple strategies to work smarter and live better, from the Fortune Well team. Sign up today.

Read More

CryptocurrencyInvestingBanksReal Estate