Monday, March 4, 2013

Do buy, or not do buy...Baidu

Very few people can claim that they do not remember their first experience with Google (GOOG). Whether it was finding a way around reading Shakespeare cover-to-cover for high school English class or checking to see how many slices of pizza it would take to wrap the circumference of the earth, every internet-using American has found their use for Google. In June 2000, before the company even went public, Google announced the first-ever billion-URL index. Take a moment and consider that number - 1,000,000,000. One billion slices of Sbarro pizza, from tip to crust, could wrap around the circumference of the earth 63 times. In four years, Google octupled that index - over one web address searchable for each person on the earth.

Impressive growth was the story for this internet company. In back-to-back years the company grew their earnings by over 240%, skyrocketing it into its role as the number one search engine of all time. From 2000-2010 the internet population in the US doubled from 124,000,000 to 240,000,000 users and the online percentage of the overall population climbed from 44% to 78% . Not only were the number of users growing, but the time spent online per user was seeing explosive growth as well. It seemed that content was infinitely pouring into the World Wide Web, and the speed to process it was doubling every couple years. The ground was fertile for a motivated, young internet company.

Now apparate 8,200 miles across the Pacific Ocean to China. According to the latest statistics, China currently has 564 million internet users - more than twice as many as the US. The craziest part? That is only 41% of China's population of 1.3 billion. Insert Baidu (BIDU). In layman's terms, Baidu is the equivalent of China's Google. The company was incorporated in 2000 by tech entrepreneur Robin Li and has since been a huge success. As of Q3 2012, Baidu held a firm position at the top of the search engine industry with an 80% share of the market in China.

Intelligence Investing:
Let's pause right there for a moment and talk about some of the principles of intelligence investing. Intelligence investing is the same as value investing (buying into solid stocks when they are down) minus the shame one feels for shopping at Walmart. One of the main tools used in this technique is the price-to-earnings ratio (P/E). The formula is simple:

Common Stock Share Price / Earnings per Share (EPS)

So basically, if ABC company profits $1 million and has 1 million shares, the EPS will be $1. If the current share price is $20, the P/E would be 20. Different industries have different average P/E ratios due to the industry's growth potential. For example, a small tech company will likely have a higher average P/E ratio than a large utilities company because the market is anticipating faster growth. 

So if P/E ratios depend on the industry, how do you know you've found a good buy? One way is to look at historical P/E ratios for the stock or the five-year average. For a steady stock with predictable growth, like McDonald's (MCD), a current P/E ratio that is lower than the 5-year average could signify a great opportunity to buy. This information can often be found on your broker's website. The information below was pulled from Fidelity:

Since the 5-year average (16.35) is similar to the current P/E  (17.85), we can assume that Mcdonald's is fairly priced (if not slightly overvalued).

Another way to see if this low P/E'd stock is a winner is by glancing at the PEG (price-to-earnings growth) ratio. The PEG ratio is calculated by dividing the P/E ratio by the annual EPS growth. If our ABC company is growing at an annual rate of 20% (remember, the P/E is 20) then the PEG would be 1. Having a PEG of one generally means that the P/E ratio is appropriate for the given earnings growth. As a PEG ratio creeps closer to 0, it indicates that the stock is undervalued and may produce higher returns*.

*Don't be ridiculous - having a low P/E and PEG will not produce positive returns 100% of the time. All of these numbers are metrics, not mathematical proofs.

My Take:
 There are very few tastier-looking fish in this pond. Baidu has taken a recent fall due to increased competition from fellow Chinese software company Qihoo 360 (QIHU) and has also tracked downward alongside the Shanghai Composite Index over the past year. I believe the fears of competition are overblown. Even if Qihoo were chipping away at Baidu's titanic market share, internet penetration rates are still only at 41% in China - where the US was 12 years ago. With that kind of growth potential I might just go over to China and start a search engine myself. The chart below shows that growth (although trending lower) is still at explosive levels. Google is still considered a groundbreaking company, but current growth levels are not near what Baidu's are.

Baidu's recent fall has put its P/E ratio at a mere 19. This is compared to its five-year average of over 53. It is rare to find lower than this company's PEG ratio of 0.64 in the tech sector (except Apple, at 0.51, but that is another blog post for another day). Oh, and did I mention? Baidu has over $5 billion in cash. 

Disclosure: I am not receiving any compensation from any of the companies mentioned. I have positions in MCD, BIDU, and AAPL. I have no positions in GOOG, but I wish I did.

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