Baidu.com (NASDAQ:BIDU) is not just China's leading Internet search provider or a Google (NASDAQ:GOOG) wannabe. It's also a time machine that has brought me back to 1999. I thought we had all learned our lesson that Internet companies with dot-com monikers and enough profits to buy a cup of coffee at Starbucks (NASDAQ:SBUX) shouldn't have multibillion-dollar market caps. I guess I was wrong, because the lunacy has returned.
Here are the underwhelming details:
Financial Performance
| 2002 | 2003 | 2004 | LTM* | |
|---|---|---|---|---|
| Revenue | $1.3 | $4.7 | $13.4 | $21.5 |
| Revenue Growth | --- | 238% | 185% | 60% |
| Net Income | ($2.2) | ($1.1) | $1.5 | $3.0 |
| Net Income Growth | --- | --- | --- | 100% |
Those are some nice growth rates, aren't they? But let's put that to the side for a second and look at the revenue and net income lines. Looking at those numbers, what do you think Baidu.com is really worth? I don't know about you, but I don't think it comes close to justifying its current $2.5 billion market cap. There is far too much hope -- and dare I say wishful thinking -- built in here that this growth trend can continue for many years.
While the growth rate has looked great, it's not that hard to put together stratospheric rates when the base numbers are so small. Since the only reason to buy Baidu.com now is an expectation that this growth will continue and one day deliver massive profits, let's consider how much the bottom line needs to increase for you to make money owning this stock.
We Rule Breakers are very patient long-term investors who are willing to wait while young companies blossom. So let's take the perspective of an investor who wants to hold for five years while Baidu.com goes through its growth phase. For this investment to pay off and make us some money, we need to see the company's market cap increase over this five-year holding period. For a small, high-risk growth company like Baidu.com, my hurdle rate would be an annual increase in value of 20%. This means Baidu.com needs to grow to a $6 billion market cap from today's $2.5 billion value to get me the kind of return I'm looking for.
What kind of earnings growth does Baidu.com need to deliver to make this happen? Take a look at this table:
| Year | Market Cap | P/E | Earnings Need to Be ... |
|---|---|---|---|
| Today | $2,500 | 40 | $62.5 |
| 2006 | $3,000 | 40 | $75 |
| 2007 | $3,600 | 40 | $90 |
| 2008 | $4,320 | 40 | $108 |
| 2009 | $5,184 | 40 | $130 |
| 2010 | $6,221 | 40 | $156 |
Data provided by Capital IQ.
To get me the 20% return I'd want to make on this kind of investment, Baidu.com would need to grow earnings from the current $3 million to $156 million by 2010. And that's using a very generous P/E ratio of 40. This means that an investor buying Baidu.com today is counting on the company to grow earnings at an annual rate of 120% for five years.
Does that look like a good bet to you?
Maybe it'll happen. Maybe it won't. But to take this kind of chance seems absurd. It makes me cringe because it looks just like the speculative insanity that we experienced with the tech bubble.
Mind you, this warning of Baidu.com's excessive valuation is not coming from a stodgy value investor who doesn't like much of anything. It's coming from someone on the Rule Breakers team who invests almost entirely in high-risk stocks. Baidu.com may be a good company, and it probably is since it has higher market share in China than Google does. But even good companies with dominant competitive positions can make for lousy investments if the price is wrong. If you like Baidu.com, I'd recommend waiting for a better price that doesn't have such strong growth already baked in.
Wait! You're not done. This is just a quarter of the Duel! Don't miss the Bull opening argument and the Bull and Bear rebuttals. Even when you're done, you're still not done. You can vote and let us know who you think won this Duel.
Fool research analyst Charly Travers has his own stool at Starbucks and uses Google all the time, but he does not own shares of any company mentioned in this article. The Fool has a disclosure policy.
