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Baidu's 1,000 PE ratio. Sure, that's sustainable...

Updated below to summarize the winners in Silicon Valley, and also to show how our analysis may not apply entirely to young companies

risk.jpgAnyone who thinks the stock valuation of Baidu, the newly public Chinese search engine company, is reasonable should consider the following:

We've mentioned before, when talking about Google, a stock is traditionally considered fairly valued if its price/earnings ratio is the same as the rate its earnings are growing. So a company with profits growing 100 percent a year would be fairly valued when its PE is 100.

It is true that Baidu is growing extraordinarily quickly. Baidu's profits are growing about 140 percent annually, according to the latest data -- much faster than Google. That's to be expected for such a young company in such a fast-growing economy like China, where Internet usage is also exploding. Ok, so you'd expect a PE ratio of 140, or maybe 300 if you know those earnings are going to keep growing strongly, and people are just dying to own the stock.

But let's do the math...(more)

First, check out Baidu's market valuation. When we first looked Baidu's stock price this morning, it was trading at $146.90. Since Baidu has 32.5 million shares outstanding, you multiply that number by $146.90 to get Baidu's total market valuation, or total price. That's $4.77 billion. So to get the PE ratio, you divide price by its earnings. It is a bit tricky to know which number to take for Baidu's earnings, because it had $1.45 million in net profit last year. It had $303,000 for the first quarter of this year -- but if you annualize that, it is actually less than the $1.45 million last year. Baidu must have had a bad first quarter or something, or maybe we're misunderstanding something (see here for yourself, page 47 has the details). Anyway, let's assume Baidu keeps growing at 140 percent, so that it reaches about $4 million this year, compared to last year. This is means Baidu's PE ratio is about 1,000 or so.

That is way out of line, and anyone betting on Baidu should buy a serious stock of aspirin -- to prepare for the possibility of what will happen within six months from now.

As we unearthed a while ago here, is appears Baidu's chief competitive advantage against Google is its music and video downloading offerings. But regulators are pressuring the company to restrict downloads that infringe on copyright laws. There have been suits brought against the company, and China has a new anti-piracy law on its books that could restrain illegal downloads in the future. So we're wondering why people seem to be missing this, even if a few other people have been writing about it too, like Techdirt, and Slashdot.

Looks like Baidu's stock has since slipped a bit over the last hour or two, but it is still above $140 last time we check (our link may show otherwise in a few days).

Finally, keep in mind what happened to the other two recent big Chinese Internet successes, online gaming company Shanda Interactive Entertainment and 51Job. Shanda ended last year at $42.50, but now trades around $38. 51Job ended last year at $55.35, but after missing its numbers and reported management issues, it has since dropped below its listing price of $14. VentureWire has a story (sub req) on this.

Postscript: We forgot to mention the big Silicon Valley winners on Baidu: (1) Pat McGovern's IDG, which has offices in San Francisco, but which McGovern took to China two decades ago, and (2) Draper Fisher Jurvetson, the Silicon Valley venture firm, which entered China with its ePlanet affiliate in 1999, beating most other Silicon Valley venture firms on the latest wave of firms seeking to invest there, and (3) Google.

In other words, this is a reward to venture capitalists who got there first, and spent time developing relationships. McGovern has been the most patient of all.

McGovern tells VentureWire that his firm's 1.45 million shares in Baidu, bought for about $1 a share, were worth roughly $178 million after the IPO. But the DFJ fund is the biggest shareholder of Baidu, with a 25% stake now worth over a billion dollars. VentureWire says it is "unclear exactly how much DFJ put into Baidu, but the firm bought 8.19 million shares over the years at a fraction of the current share price." (Update: Jeff Clavier has provided the details below in comments.)

Finally, Google took a 2.6% stake in Baidu last year.

Update: Michael Brush forwards his excellent critique of our analysis. The point is, PE works less well for younger companies:

When a company is young or "emerging," it typically has minimal earnings compared to its potential. At this stage of a company's development, p/e ratios are not meaningful.

Yes, you can say a company earned a penny and it trades for $100 so it has an absurd p/e of 10,000. But p/e ratios like these in the early stages of a company's development are irrelevant. The p/e may be high partly because the stock price is so high, but primarily because earnings are minimal since the company is still in the early stages.

It's better at this point in a company's life to use some other valuation measure like discounted cash flow (DCF), or some sort of comp analysis, ie. how much would this company go for, based on what similar companies sell for. I am sure the sell side walked through scenarios like these in the prospectus. I'm not saying Baidu is fairly valued -- just that there are other ways to measure that which make more sense.



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Comments

According to this registration statement (http://sec.gov/Archives/edgar/data/1329099/000119312505156223/df1a.htm) DFJ ePLanet seems to have invested $12.5M in the Series B ($7.5M) and Series C ($5M) in the company.

Jeff Clavier on August 8, 2005 10:46 AM
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Thought you would find this article interesting...
Looks like P/E Ratio is the same as the rate our earnings (profits) are growing.
So if profits y/y are growing x% P/E is x.

Also read the last two paragraphs: it talks about P/E ratios not being useful or the yard stick for start-ups since our potential is not part of the equation.

Also - search is on fire. We need to get in that game.
me

Nicole Fler on August 9, 2005 6:58 PM
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Baidu is China's Google.

Based on this information, last Friday Wall Street gave a company that did a $15 million in revenues last year a $4 billion dollar market capitalization.

Notice anything eerie?

Yep, looks like the Bubble all over again.

While Baidu is the dominant search engine in an emerging economy, I cannot fathom how a company whose net income in 2004 was a paltry 1.5 millon can raise $100 million dollars in the capital markets.

I thought after the Crash, days like these were over.

The Wall Street Journal said that Friday's IPO captured "the biggest first-day gain since the heady days of the dot-com boom."

Some things never change.

It's clear things are out of whack again in the stock market.

First of all, investors got too giddy because Google has a minority stake in Baidu (looks like another masive paypday for Google insiders).

Second, Baidu's fundamentals are totally out of sync with their current valuation, as I suggested above.

Search is a maturing market.

If anything, Baidu will be bought out rather than them developing any new and unique product or technology.

Third, investors should know that Chinse users are less dependent on one search engine.

Ultimately, I think Baidu will turn into another day trader's stock.

The average trading volume (22M) is 5x the number of shares outstanding (4M).

Which means that each share exchanges hands five different times before the market closes at 4Pm.

First day "pops" on IPOs are great for early investors and insiders, but not so great for current and future employees of the company, who typically watch their morale drop as the price of the stock does.

But for the bankers and insiders, Friday's offering was an obvious windfall.

Wall Street isn't about small investors or company employees.

That's a fallacy.

Wall Street is about bankers and institutions.

And IPOs are about timing.

With Chinese stocks still in the hot zone, the Baidu IPO was ripe for the picking.

Catablast! Media on August 10, 2005 1:28 AM
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Coverage of the Baidu IPO (BIDU)
http://www.seekingalpha.com/2005/08/coverage_of_the.html

Dimitar Vesselinov on August 10, 2005 4:29 AM
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There is a common myth here. The myth of the PEG ratio. If PE is theoretically supposed to equal growth rate, consider this example. A growth rate of 100 and PE of 100. In one year, the earnings will grow 100% and the PE will be 50. The next year the stock will again double earnings to a total that is 4 times where it was two years ago. Then next year, 8 times the earnings three years ago. This gives us a PE of 12.5 after 3 years. Does this valuation of PE 100 in the first year make sense? Absolutlely not. In theory, markets are efficient, and the valuation should account at least the next few years of growth, with some speculation of years beyond, AND a discount for risk. Therefore, with efficieny in mind, if we think the stock's earnings will grow 100% for the next six years, our valuation should be as follows (lets assume a market average of 15, even though the current market average is 18): PE 15 x 2^6 (six years of doubling earnings) = 15 x 64 = 960. The PE should be near 960 in an efficient market.

Let me give you a better way to sum up Baidu with some simple math. Google's market value: 97 billion. Yahoo's market value: 49 billion. Baidu's market value: 2 billion.
That said, given my own in-depth analysis of Baidu, my target market value for next 2-3 years is 7.6 billion. That entails a stock price of 235. Given that I bought the stock at 66.80, I am hopeful for the future. The bubble of the late 90's was mostly in stock with no earnings. Watch Baidu's stock today, 10-26. Its a big day.

Steven on October 26, 2005 6:31 AM
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