Alibaba's coming out party: Valued right, but is it priced right?

Aswath Damodaran's picture
Rank: King Kong | 1,612

As Alibaba's IPO approaches and the road show kicks into high gear, questions about its accounting, value and corporate governance that came up at the time of the filing of its initial prospectus on May 6, 2014, are resurfacing. Alibaba's banking team announced on Friday that their initial pricing for the stock would between $60 and $66 a share, giving the company an estimated an equity value of about $155 billion at the pricing midpoint. That would make it the most valuable IPO in history, much higher than the $80 billion at which Facebook's equity was priced at the time of its IPO in 2011 or the $25 billion at which Google priced itself in 2004.

Valuing Alibaba
I valued Alibaba in May 2014, right after their initial prospectus was filed in this post which I titled "Alibaba: A China Story with a profitable ending?". In that post, I argued that Alibaba's dominance of the Chinese online retail market provided a foundation for immense value, driven by the size of and the growth in that market and sky-high operating margins. While I will not repeat the specifics of the valuation here, the combination of high revenue growth, sustained margins and relatively low reinvestment, I argued, yielded a value of $145.6 billion for the company and a value per share of approximately $61/share.
Much has happened in the five months since: Alibaba has navigated its way through some accounting quicksand, rumors surfaced of an investment in Snapchat that valued the company at $10 billion though the deal fell apart, and Alibaba updated its prospectus to reflect an additional quarter of information. Since a few months can shift both the numbers and the narrative for a young company, I revalued the company on September 2, 2014 (it was the first valuation of the week in my Fall valuation class) using Alibaba's filing from August 27, 2014. While there a few tweaks to the valuation, my assessment of the company has changed little. The value of equity that I get, allowing for an initial offering proceeds of $20 billion, is $161 billion, with about half of the increase in value   coming from a larger initial offering, and the value per share that I get for the company is about $66. The picture below captures my assumptions and you can contrast it with my earlier valuation from May, if you are so inclined:
You can download this valuation in spreadsheet form, by clicking here.

In keeping with my posts on narrative and numbers, the key question is whether there is anything that has happened in the last few months that has changed my narrative of Alibaba as a dominant, profitable Chinese online merchandiser and the answer is 'not yet'. The reason that it is not an emphatic no is that some of the actions taken by Alibaba in the last few months, including a rumored investment in Snapchat, suggest that it has ambitions to become a global retail giant, competing with Amazon, Google and even Facebook. In the quarters to come, if these actions become more concrete and costly, I will revisit this valuation to see the effects, positive and negative, of this narrative shift.

I have a few emails in the last few days asking whether I feel vindicated by the fact that Alibaba's bankers seem to have arrived at a number very similar to mine and my reaction is mixed. First, given what I think about the valuations that emerge from investment banks in general, I am queasy that I am in agreement with their assessments of Alibaba's value. In fact, it is entirely possible and perhaps likely that both the bankers and I are hopelessly off track on our assumptions and that the true value is a number very different from our assessment. Second, and repeating a point I have made on prior posts about IPOs, bankers don't value companies in IPOs; they price them and the fact that they are thinking of pricing the company close to my estimate of value is, in my view, more coincidence than a reflection of consensus.
Pricing Alibaba
When asked to attach a number to an asset, I believe that you have to start with a fundamental question: Is your mission to attach a value to the asset or is to price the asset?  If your job is to facilitate a transaction or get a deal done, as is the case with bankers in an IPO, you have a pricing mission and we would all save ourselves significant disappointment and disillusionment, if we remembered that. In effect, Alibaba's bankers have to price the stock for the IPO, not value it. To get to the right price for a company in an IPO, there are five key steps involved, though one of them is purely for external consumption.
  1. Use pricing metrics and comparable firms to arrive at an estimate of what investors will pay for the shares: Those pricing metrics take the form of multiples of earnings, book value and revenues and the comparable firms are other publicly traded companies that you believe investors will compare your firm to. The process clearly has subjective judgments in it, in your choice of multiple, in what firms you include in your comparable list and how you control for differences. The table below provides the range of estimates of equity value that I obtain for Alibaba, depending on which multiple I use (PE, Price to Book Equity, EV/EBITDA, EV/Sales or EV/Invested Capital), what I choose as my comparable firms (Just Baidu, Online Advertising, Online Retail, Online Services or all Online companies) and how I compute my sector average (Simple average, Median, Aggregate values). I can get values ranging from $11.9 billion (using the EV/Sales of online advertising companies) to $944 billion (using the simple average PE ratio of Online service companies), and while this may strike you as absurd, it also points to why how easily relative valuations can be used to justify almost any point of view or sales pitch. With Alibaba, at least, it seems clear to me that if multiples are used in the road show, they will almost always be earnings-based (since you get much higher values with those than with revenues or book value) and that the comparable firms will be pruned to create a sample that makes Alibaba look cheap. You can download a spreadsheet that lets you alter the choices and one that contains the raw data on individual companies.
    Alibaba equity value: Based on Trailing 12-month numbers. With EV multiples, I add cash and subtract out debt to get to equity value
  2. Gauge demand: If pricing yields such a wide range of numbers for Alibaba, how do you arrive at a price for the initial offering? The answer is surprisingly simple. The bankers setting the price start by getting a measure of how much potential investors (especially larger ones) are willing to pay for the stock and gauging demand. If investors seem too enthusiastic at a specified price, they will move the price up, whereas a muted response will lead to a lowering of the price. 
  3. Build in the "pop": For better or worse, bankers are not feted for getting the price right but for getting it wrong, albeit in one direction and not by too much. A well-priced IPO is one where the stock jumps on the offering date by about 10-15%, relieving bankers of their underwriting responsibility, rewarding key clients (who were able to subscribe at the offering price) with a  quick profit and providing press buzz and price momentum for the issuer to make subsequent offerings. I may be reading more than I should into Alibaba's initial pricing numbers, but the fact that the offering price is set at $63 ($155 billion) suggests to me that the bankers believe that a fair price for the stock is about $180-$200 billion.  
  4. Reverse engineer a "valuation" to back up your price: For some reason, bankers seem to believe that they have to cloak their pricing in a value framework, i.e., make it look like the price that they have arrived at is really the result of an intrinsic valuation. Thus, a DCF valuation is created, inputs are tweaked and first principles are often mangled to arrive at the desired number (from the first three steps). To be fair to bankers, this step in the process may be designed to prevent legal jeopardy, since courts seem to also think that due diligence in this process requires a DCF valuation. 
  5. Reassess demand: While we think of roadshows as designed to help the issuing company and its bankers make their sales pitch to investors, the information flows both ways, as investors' views and reactions can help bankers reassess their offering price range. The final offering price does not have to be set until the day before the offering date, leaving plenty of time for adjustments and readjustments. 

After all of this effort on pricing, you would think that the bankers/issuing company would get it right, but as Facebook and Twitter illustrated in divergent ways, it is easy to get it wrong, with the offering price set too high for Facebook and too low for Twitter. As to how Alibaba will fare on opening day, your guess is as good as mine, but if the stock does jump about 15% on the opening day, the company and its bankers will celebrate a Goldilocks pricing moment. 

Investing or Trading
Should you invest in Alibaba? At its estimated offering price of $150-160 billion, I think that it is a fairly-valued investment, if you can overcome two fears. The first is that, as a shareholder, you are not becoming part owner of Alibaba, the Chinese online merchandiser,  but instead get a share of a shell entity (the Cayman Islands based variable interest entity) that controls the operating company through a legal agreement (that exists because the Chinese government treats it as such, for the moment). The second is that you are buying a corporate governance nightmare, where this will remain Jack Ma's company for the foreseeable future and you will have no say in what the company does, how it is overseen or its management decisions. I will return to the issue of corporate governance, why it matters and how best to incorporate it into value in another post. I, for one, will stick with my indirect investment in Alibaba, through Yahoo!, and hope that I get the spillover benefits.

Should you trade Alibaba? That will depend on whether you are good at playing the pricing game and I drew the distinction in this earlier post. Since I am not particularly good at this game, my advice on this count is worthless, but if you do play the pricing game, recognize that your capacity to make money will come from assessing investor mood and stock price momentum.

Attachments
My last post on Alibaba (May 2014)
Valuation of Alibaba (DCF spreadsheet) on September 2, 2014
Pricing/Relative Valuation of Alibaba Spreadsheet
Raw Data on Comparable firms

http://www.aswathdamodaran.blogspot.com.ar/2014/09...

Comments (12)

Sep 9, 2014

bookmarked for weekend reading, thanks Dr. Damodaran.

PS: I love your youtube series on investment philosophies, have you ever considered doing a coursera course?

Dec 21, 2014

delete

Sep 9, 2014

fyi he doesn't check this regularly so might want to post the question on the original post http://www.aswathdamodaran.blogspot.com.ar/2014/09...

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Sep 9, 2014

I went to the IPO roadshow and a few quick thoughts:
* It was all about stories of how Alibaba helped small businesses achieve their goals. This wasn't a traditional pitch but maybe that's the way things are heading.
* Jack Ma presents well and is a likeable, almost folksy (Warren Buffet-esque) leader; I was impressed to learn that his english is self taught
* They got asked questions on corporate governance and on the lack of transparency with AliPay and the answers were awful - along the lines of "you'll just have to trust us"... that makes me wonder if everyone has forgotten the Chinese stock scandals of '07 to '10. Here too, you probably are fine as long as the Chinese economy is fine.

I haven't heard any indications on pricing, but I'm sure it'll move to at least the top end.

Sep 9, 2014

Professor Damodaran refers to pricing corporate governance risk in his post.

I'd love to see his thoughts in pricing in the China governance risk eg how to price the risks innate in Chinese (and many other emerging economy) businesses, where you have not insignificant risks of the Party and government:

- Directing a Chinese business to act on political policy grounds rather than on purely profit-seeking grounds (bearing in mind that acting as the CCP wants you to act does avoid losing profits)

- Deciding they don't like some aspect of what you're doing and putting a stop to it - a more significant risk than the regulatory risk in Western systems

- Imposing regulatory curbs on Alibaba's potential growth (eg the restrictions Alibaba ran into with Alipay, as the government would not permit foreign ownership in areas of financial services)

- Cracking down on the current legal device used to circumvent foreign ownership restrictions in companies that hold Chinese internet content licenses

(and there are others)

I've seen some people address this through adding a risk premium to discount rates, but that doesn't make conceptual sense, as the discount rate is supposed to represent a non-diversifiable systemic risk perspective. Risks you can diversify away from through geographic diversification should, instead, be represented in probability weighted cash flows in a DCF analysis.

I'm very keen to hear how the Professor addresses the types of risks in his Alibaba valuation. Are they considered too far along the tail to incorporate? Or too hard to incorporate?

Sep 10, 2014

My concern is the ties to the Chinese market. Given the facts that Alibaba is not globally diversified if the predicted Chinese Housing Market crashes it is pretty doomed. There is also a concern for the Chinese shadow banking since it is a player in this equation. Alibaba does have a solid return and it is very good in the Chinese market but it is a short-term winner until it has demonstrated good governance.
@Grosse did they discuss their diversification strategy to address those concerns?

Si Vis Pacem Para Bellum

Sep 10, 2014

Yes, they did discuss diversification, but again very broad.
The comments were "we are an internet company that happens to be in China" and that they see their solutions which enable small businesses being relevant globally. They got a question on the idea of building a similar presence in India, but it was a 15 second answer like "and we think there's a lot of opportunity elsewhere in Asia; we think businesses in India or New Zealand could benefit and are thinking about how we could serve those markets".

The compelling statistic, to me, was that China has 1.3B people, just less than half are on the internet, and only half of that number are people who shop online. Alibaba has very high penetration of the # who shop online and has great brand recognition.

So I doubt they'd be making moves outside of China any time soon, as there's another 600m+ people to bring online, and a significant number of people who aren't using the internet to shop through Alibaba.

If you want to own this stock, you've got to believe that China won't have a hard landing and/or that the internet shopping opportunity far outweighs macro risks.

Sep 11, 2014

Good write up. Personally I wouldn't put money on them at any price, there are just too many scandals and stories coming out of China.

Sep 12, 2014

As a Chinese, I shall say Taobao which attached to the Alibaba played an important role in making profits (though I a can't find any data from raw data link because the link has been dis-abled for some how). When I was in my college in China lots of girls stay in dorms whole day and buy all the stuff (except for there everyday meal) through Taobao)

I take a look at your model...it looks good...I am just curious about with so many years passed, Alibaba still keeps a revenue growth rate at 27% and will remain the rate for at least 5 years. This will definitely result a high Free Cash Flow in the end but I just don't know how you came up with the 27%)

Javier

Sep 13, 2014

YHOO is up 27% from when the Professor wrote his post "Yahoo! A puzzle, a mystery and an enigma". Not too bad.

Sep 16, 2014

I am going to spend my weekend on your lectures Professor!!! Thanks for your contributions to our learning!

Sep 16, 2014
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