Baidu (NASDAQ: BIDU) is the largest online search company in China and, with a market cap north of $70 billion, one of the larger companies in the industry. Based on its return on assets, return on equity, price-to-book ratio, and price-to-equity ratio, Baidu currently looks like a good opportunity for investors to snap up shares of a great company at a fair price.
When using financial ratios to value a public company there is no magic bullet that tells investors if they should be buying or selling. If there were, everyone would use this number and the market would be perfectly efficient. However, comparing a blend of some commonly available numbers against those of other companies in the space provides a good start for determining whether a stock is worth owning. Keep in mind that these numbers must be used along with a knowledge of the underlying business. One set of information complements the other, and the best investors will know both well.
Baidu is often called the "Google (NASDAQ: GOOG) (NASDAQ: GOOGL) of China," while Yandex NV (NASDAQ: YNDX) if often referred to as the "Google of Russia." In this comparison with Baidu, I will look at Yandex, Google itself, and Baidu's biggest domestic competitor, Qihoo 360 (NYSE: QIHU).
Return on equity
Return on equity is a good place to start when deciding whether to invest in a company. It shows how good a company is at turning shareholder equity into profits. Shareholder equity is total assets minus total liabilities. If considering two companies in the same industry, all else being equal, the company with the greater ROE is better at generating profits for shareholders and is the better investment.
Return on assets
In a simple example, return on assets will be the same as ROE if a company holds no debt on its balance sheet, but will be lower if it does. This number measures how much a company earns for every dollar of assets it holds. If two companies both earn $1 million per year, and company A does it from a $5 million asset base while company B does it with a $50 million asset base, all else being equal, company A is a superior investment.
ROA is calculated by multiplying net profit margin by average asset turnover. Average asset turnover shows how effectively a company can use its assets to generate sales. There is a loose inverse correlation between net margin and average asset turnover. A company can achieve an ROA of 10 by having a net margin of 2.5% and turning over its whole asset base 4 times, which would most likely be a high volume retailer. Or, that same ROA of 10 could be achieved by having a net margin of 30% and only turning over one third of the asset base in a year. The four companies in this article have average asset turnovers ranging from 0.54-0.61, meaning that nearly all difference in ROA is due to differences in net profit margin.
Price-to-book is the share price divided by the book value, or liquidation value if you sold off all the assets of a company. If ROE is high and P/B is low that is a good sign that the company may be undervalued and warrants a closer look.
P/E is probably the most commonly cited valuation tool. It's another tool in the toolbox but is crude to use by itself since the denominator can jump wildly. While current numbers are useful and accurate, because we know the earnings already, the key to investing is figuring out future earnings and thus the forward P/E. This is where understanding the business comes in.
Let's look at our four companies' ROE and ROA on a trailing-12-month basis, along with the current P/B and P/E ratios.
|Company||Return on Equity (TTM)||Return on Assets (TTM)||P/B (Current)||
As we can see, all four companies have solid ROE and ROA. Google's lower ROE is balanced by its lower P/B ratio. I have green-thumbed Baidu, Google, and Yandex on Motley Fool CAPS, and I own Baidu personally, so I like them all. Qihoo 360 has been taking market share from Baidu in China, and with a market cap of only $8.8 billion it might be a more speculative way to invest in this growing Internet market.
I think the hard numbers mentioned above for Baidu are very solid for a business of its size, with tremendous growth potential ahead. I'm comfortable that its valuation is fair when viewed next to its competitors and thus an investment decision comes down to analyzing the business itself. It is the dominant player in the biggest (and still growing) Internet market in the world, and has a dedicated founder and CEO at the helm who could very well be there for decades to come. China has proven to be a very fickle market for foreign companies and this provides some protection for Chinese companies like Baidu. It will face domestic pressure from companies like Qihoo 360 but should be able to retain the lion's share of an ever growing domestic pie. Because Baidu controls less than 1% of global search market share, with over 90% of its search engine visits originating from China, there is an opportunity for incremental gains in other markets to have a large effect on the company. Baidu is poised to expand its core business internationally as well as continue to leverage the Baidu brand within China. Its video site iQiyi has already become the main competitor to Youkou, which has been referred to as the YouTube of China. Given these strengths, I think Baidu belongs on a tech investor's watch list.