Two weeks ago, I wrote an article about JD.com (JD, Financial). In it, I reflected upon my journey with the company and why I lost confidence in JD’s future prosperity and management team. Since then, I have received quite a few comments and questions on my decision. The most common comment/question is regarding the valuation of JD. Many argue that because JD’s trading at a historically low trailing 12 month price-sales ratio of below 0.7, the shares are attractive.
Some suggested that I sold JD.com (JD, Financial) because the price dropped. Well, Alibaba (BABA)'s share price also declined quite a bit when I decided to add to my positions.
At the end of my previous article, I wrote the following:
“Valuation matters, but when the management team and the competitive environment changes, it’s time to remember the adage, ‘Not everything that counts can be counted, and not everything that counted truly counts.’ In terms of multiples, JD’s appearing very cheap now. But as the moat has narrowed considerably, JD’s probably more expensive now than it was two years ago when the multiple was higher.”
With JD.com, I encourage investors who use sales-based multiples to reconsider their valuations. In an article I wrote in March 2014, I explained the merits and limits of using the sales-based ratio. Here is a recap:
"Essentially, the P/S ratio is a simple valuation metric calculated by taking the company's market capitalization and dividing it by the company's total sales over the past 12 months. The popular wisdom says the lower the ratio, the more attractive the security.
- P/E is meaningless for companies suffering from losses.
- Sales number is harder to manipulate than earnings.
- Because sales tend to be more stable than earnings, P/S can be a more reliable indicator for companies with fluctuating earnings patterns.
A common misuse of P/S ratio, especially when comparing investment opportunities, is the failure to consider the impact of margin, which varies vastly from industry to industry, on the P/S ratio. Put into other words, the P/S ratio is not a useful metric when viewed separately from operating margins. Very often an investor choose one investment over another based on the lower valuation implied by the P/S ratio.
A dollar of sales at a highly profitable firm is worth more than a dollar of sales for a company with narrow profit margins."
When valuing JD.com, the most important thing is to assess the future normalized earnings power of the business. That means we have to guess:
- Whether JD will be profitable in the future.
- At what level of sales will JD be profitable.
- If JD can achieve stable profitability, what is a reasonable guess of the net margin of the business?
As you can see, it’s not easy to answer these three questions. What we can do is to constantly take in new evidence and consider whether they lead to the narrowing of the moat, which leads to lower profitability, or widening the moat, which leads to higher profitability.
I’ll use simple math to illustrate my point.
For calendar year 2017, JD’s sales were about RMB 362 billion, up 40.3%, which is pretty impressive. If JD can compound sales at a 25% CAGR until 2022, by then, JD’s sales would be approximately RMB 1.1 trillion. The question becomes whether JD can earn RMB 11 billion (at 1% margin) or RMB 66 billion (at 6% margin). If JD can only earn 1% on sales, then at the latest closing price and exchange rate, JD is trading about 23 times 2022 earnings. But if JD can achieve a 6% net margin, then as of the latest closing price and exchange rate, JD is trading about less than four times 2022 earnings. When I first invested in JD, I thought the earnings power of the company was closer to 6% than 1%. As more evidence came in, my estimate of JD’s earnings power became gradually closer to 1% than 6%.
Therefore, it seems appropriate for me to reword my previous lesson:
“In terms of sales-based multiples, JD’s appearing very cheap now. But as the moat has narrowed considerably, JD’s earnings power has declined dramatically so in terms of earnings-power based multiple, it is probably more expensive now than it was two years ago.”
It doesn't mean JD's price will not go up a lot from here. If that's the case, it won't bother me at all. It also doesn't mean my assessment of JD's future is right. I could be very wrong in my assessment.
In the end, I want to add one more important lesson:
"To hold on to previous conclusions just to appear consistent and infallable is tempting as it is human nature, but doing so also dampens our growth in the long term."
