It is rare to see Alibaba Group Holding Limited's (NYSE:BABA) price-to-earnings (or "P/E") ratio of 19.1x be as close as the U.S. market median P/E of 18x. Further, the business itself is still growing, and the company is still in a dominant position amongst Chinese competitors. However, as we all know, the main risk lies in the government's approach towards the company, and today, we will examine the risks of investing in a Chinese company and what does the current P/E mean for Alibaba.
The Risks of Investing in Chinese Stocks
The most important thing to note, is that investors are not shareholders in Alibaba. They are in-fact shareholders in the Cayman Islands Shell Company that represents Alibaba (This is known as a Variable Interest Entity - VIE). It is this company that is listed in the NYSE, and has a contract with the Chinese entity to represent their operations.
The SEC explains this structure in detail, and a high-level blueprint can be depicted with this chart:
What we can see is, that as investors in Chinese stocks, we have multiple degrees of separation. The reason for this, is that the Chinese government has soft regulation preventing U.S. investors from owning equity in Chinese companies. And while these companies were growing, in effect subsidized by U.S. and international investors, the government has been passive, however in the last few months they have started a campaign which began with a crack-down on tech companies.
The very worse case scenario, that might happen, is that the government announces to the companies that they are (and they actually possibly are) in breach of the law, and will be penalized for it by forcing them to cut ties with U.S. investors.
Every investment thesis on Chinese stocks, carries with it the assumption that this does not happen.
A Great Price for Earnings
Assuming that this big IF, doesn't happen, we are going to look at how expensive or cheap Alibaba is a stock for investors.
Alibaba has a P/E close to the U.S. Market median, however the company is in the technology sector, and the 26.7x P/E is much more representative of how similar companies in this industry are priced.
The 19.1x P/E is the lowest the ratio has been since 2016.
It is very likely, that on a pure P/E ratio basis, the company is currently a bargain.
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The Growth Of Alibaba Group Holding
There's an inherent assumption that a company should be matching the market for P/E ratios like Alibaba Group Holding's to be considered reasonable.
If we review the last year of earnings, dishearteningly, the company's profits fell to the tune of 18%.
Still, the latest three-year period has seen an excellent 141% overall rise in EPS, in spite of its unsatisfying short-term performance. Although it's been a bumpy ride, it's still fair to say the earnings growth recently has been more than adequate for the company.
Looking ahead now, EPS is anticipated to climb by 5.3% per annum during the coming three years, according to the analysts following the company.
With this information, we find it interesting that Alibaba Group Holding is trading at a fairly similar P/E to the market.
As discussed, investing in VIE's ties to Chinese companies carries with it a different kind of risk. If that risk is acceptable for investors, then it is likely that Alibaba is currently trading at a cheap price as a stock.
Additionally, the stock is expected to further grow both revenues and profit, which makes it a growth stock with value underneath. That is rare to come by, but the additional risk factor warrants caution.
Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.
And what about other risks? Every company has them, and we've spotted 2 warning signs for Alibaba Group Holding you should know about.
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Simply Wall St analyst Goran Damchevski and Simply Wall St have no position in any of the companies mentioned. This article 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.