I can’t believe I’m saying this.
A hyper-hyped Internet company has whipped investors into a frenzy, rendering them willing, even eager, to crawl over broken glass to get shares. It feels like 1999, and we know how that turned out. Yet an analysis of Alibaba’s financial statements, done in a way that’s extraordinarily revealing and that has not been described elsewhere, shows that the stock actually looks like a good buy at its offering price of $68 a share.
This analysis is distinctive because it looks at economic profit, the measure that best shows how a company is performing. Research has found that stock prices track economic profit much more closely than they follow more popular measures like earnings per share. Economic profit told me in 1999, for example, that AOL was insanely overvalued (a contrarian view at the time, believe it or not) because its stock price could be justified only by future economic profit increases that were clearly impossible. That same kind of analysis suggests that Alibaba’s IPO valuation is—dare I say it—reasonable.
The concept of economic profit is simple: Take a company’s operating performance—its net after-tax operating profit—and subtract the cost of the capital (debt and equity) that was used in producing that profit. Accounting rules don’t require companies to calculate that figure, but companies as diverse as Coca-Cola, Deere, Whole Foods, and Walt Disney calculate it anyway because it’s so useful. It has long been calculated for thousands of public companies by the consulting firm EVA Dimensions, which performed the research I cite here. (EVA means economic value added, another name for economic profit.)
Alibaba is an economic-profit superstar. The amount of economic profit it produces per dollar of sales—its “EVA margin”—is “off-the-charts great,” says Craig Sterling, global head of equity research at EVA Dimensions. It was 36% over the most recent four quarters. The same measure for Facebook is 27%; for Apple and Google, it’s 14%; the median among the Russell 3,000 firms is about 2%. So Alibaba is almost literally off the charts.
What counts for investors, however, is not what you’ve done but what you’re going to do. The EVA Dimensions team has put together a detailed forecast, which we’ll take a look at, but I like to start with a simpler question: What’s the minimum future performance the company would have to achieve in order to justify the current stock price? And is it even reasonable to think the company might achieve it? That’s the test that AOL failed in 1999. But Alibaba passes it easily.
Consider that Alibaba’s sales increased 48% over the past four quarters; let’s imagine that that rate declines steadily and, after 10 years, settles down to a long-term rate of just 1% annual sales growth. That EVA margin of 36%? Let’s suppose it shrinks to a 10% long-term rate. Calculate the present value of that future performance, built on very modest assumptions, and you get a stock value of $71.44, or slightly more than the stated offering price. In other words, it seems reasonable.
Here’s an even easier way to think of it. A $68 share price is justified if Alibaba increases its economic profit by $1.2 billion a year for the next decade. Is that plausible? Absolutely. The company increased its economic profit by $1.3 billion last year, so with sales growing, it could hit its target even if margins shrink.
But you could argue that Alibaba merits considerably brighter expectations. The EVA Dimensions team forecasts, for example, that over the next 10 years, Alibaba’s sales will grow by a factor of 8.6, to about $79 billion. Outlandish? Not when you consider that sales at Amazon, a much bigger company in a very similar business, have increased even more over the past 10 years—by a factor of 10.7, to about $82 billion. Consider also that Amazon has achieved its stellar growth by operating mostly in the pokey old North American economy, while Alibaba does most of its business in the world’s fastest growing major economy, China.
The EVA Dimensions team also assumes that Alibaba can maintain its knockout EVA margin at around 36% over the next 10 years. That seems like a stretch to me—I don’t believe any large company has ever done that—but if you accept it, plus the analysts’ assumption that long-term annual sales growth will in fact level out at 4% after a decade, you get a stock value of $130. Wowie.
While that 36% EVA margin assumption may be too ambitious, the 4% long-term sales growth assumption may actually be too conservative. After all, Amazon is about a decade further along than Alibaba, and it grew sales by 22% last year. The comforting thing is that you don’t need ambitious assumptions, or anything close, to justify an Alibaba share price of $68.
The most disturbing thing about the Alibaba IPO is the mania surrounding it. But let’s remember that other ultra-hyped tech IPOs, such as Google and Facebook’s, have turned out to be magnificent investments. At least they have if you got them at the offering price. The test will be what happens in the hours, days, and weeks following the IPO. If the price rockets, we’ll know that we’re seeing the madness of crowds, just like in 1999.
