Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Alibaba Group Holding Limited (NYSE:BABA) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (CN¥, Millions)
CN¥171.5b
CN¥179.2b
CN¥225.3b
CN¥175.0b
CN¥157.1b
CN¥151.1b
CN¥148.1b
CN¥146.9b
CN¥147.1b
CN¥148.2b
Growth Rate Estimate Source
Analyst x11
Analyst x11
Analyst x8
Analyst x3
Analyst x2
Est @ -3.79%
Est @ -2.01%
Est @ -0.76%
Est @ 0.11%
Est @ 0.72%
Present Value (CN¥, Millions) Discounted @ 8.7%
CN¥157.8k
CN¥151.7k
CN¥175.4k
CN¥125.4k
CN¥103.5k
CN¥91.6k
CN¥82.6k
CN¥75.4k
CN¥69.4k
CN¥64.4k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CN¥1.1t
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥2.3t÷ ( 1 + 8.7%)10= CN¥1.0t
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥2.1t. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$86.7, the company appears a touch undervalued at a 23% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
NYSE:BABA Discounted Cash Flow October 1st 2023
The Assumptions
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Alibaba Group Holding as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.7%, which is based on a levered beta of 1.079. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
SWOT Analysis for Alibaba Group Holding
Strength
Earnings growth over the past year exceeded the industry.
Debt is not viewed as a risk.
Weakness
No major weaknesses identified for BABA.
Opportunity
Annual earnings are forecast to grow faster than the American market.
Good value based on P/E ratio and estimated fair value.
Threat
Revenue is forecast to grow slower than 20% per year.
Looking Ahead:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Alibaba Group Holding, we've compiled three further elements you should explore:
Future Earnings: How does BABA's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
