I Believe in Baidu

If you want to split a room in half just ask the people in it if they're bullish or bearish on Baidu (NAS: BIDU) .

China's leading search engine has no shortage of critics. The country's restrictive nature, the questionable accounting authenticity of some Chinese dot-coms, and the raw valuation of Baidu make it a hard stock to love for some worrywarts.

However, there's an equally vocal bullish camp -- where I pitch my tent -- arguing that the company's growth rate, the emerging nature of China's economy, and its expansion potential make it one of the most misunderstood stocks around.

Ripping Into the TMFULOI
Fellow Fool Sean Williams created an index two months ago. TMFULOI -- or TMFUltraLong Overvaluation Index -- essentially adds up a stock's price-to-book, price-to-sales, and price-to-cash flow ratios. The highest numbers among profitable companies get tossed into the index.

Baidu, as you can imagine, made the cut. Four of the five biggest offenders were Internet companies, and Baidu grabbed the silver.

As a reader, I know that we can confuse you.

A month after I wrote about the reasons Baidu is a bargain under $130, Sean's singling out Baidu as one of five stocks worth selling. We're not trying to send a mixed message here. We're just investors writing for investors. Remember that divided room? We're just on different sides this time.

My problem with TMFULOI -- conceding that Sean's developed one more gauge than I ever have -- is that it penalizes fast-growing companies. The book, sales, and cash flow multiples provide compelling snapshots, but they do little to measure growth.

That's pretty substantial, especially when it comes to Baidu. Revenue climbed 75% in its latest quarter, and margins expanded to allow earnings to soar 76%. Oh, and that was seen as a relatively weak quarter out of China's dot-com darling.

What does this have to do with TMFULOI? Well, heady sales and profit expansion have a nice way of bringing price-to-sales and, typically, price-to-cash flow ratios down. In the two months that passed between Sean creating the TMFULOI and checking back earlier this week, Baidu's stock may have shed 17.5% of its value (on the poorly received report, but mostly as the result of tech stocks getting clobbered in April and May) but the TMFULOI has declined 47% to 65.1.

If a single quarterly report and a slight downtick in valuation is enough to cut Baidu's price-to-cash flow by more than half, just imagine what a few quarters of healthy growth will do.

Margins of error
Another shortcoming of TMFULOI is that it penalizes high-margin companies. If you want an investment with a low price-to-sales ratio, please knock yourself out and buy a supermarket. You'll be snoozing, but you'll grab that low number given the nature of the grocery store industry.

Baidu, on the other hand, milks far more out of every dollar -- or yuan -- that it receives. Baidu's trailing net margin clocks in at 45.6%. If you want to know how spectacular that is, consider that Google (NAS: GOOG) checks in at 27.1%. Russia's Yandex (NAS: YNDX) -- which also makes Sean's TMFULOI list -- is sporting net margins of 28.2%.

How can it be that global leader Google is generating softer margins than regional search engine faves? Well, that's easy. Running a successful business is less cost-intensive in emerging markets. China's tax rates are also far kinder than what Google faces on its stateside profits.

Put another way, Baidu's price-to-sales multiple of 16 may be high, but turning 45.6% of that revenue into after-tax earnings results in a trailing P/E of 35. That's not cheap, but it adds perspective. Trendy yoga apparel retailer lululemon athletica (NAS: LULU) is fetching half the sales multiple Baidu does, but its trailing P/E is 45.

Oh, and that's not a knock on Lululemon. It's just a way to illustrate that cherry-picking metrics to determine valuation is rarely a fair or complete metric.

Growth matters. Margins matter. Making a valuation call on Baidu will still split the room, but you'll be a better investor if you recognize what both sides are seeing.

Bullish on Baidu
A bullish call on Baidu has served me well on Motley Fool CAPS over the years. True to the CAPScall initiative, I'm not going to give up on it now. Baidu has soared 1,300% since I recommended it to Rule Breakers newsletter subscribers six years ago, but now it's time to discover the next rule-breaking multibagger. It's a free report. Want it? Get it.

At the time thisarticle was published Longtime Fool contributor Rick Munarriz calls them as he sees them. He does not own shares in any of the stocks in this story. Rick is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.The Motley Fool owns shares of Baidu and lululemon athletica. The Fool owns shares of Google.Motley Fool newsletter serviceshave recommended buying shares of Google, Baidu, and lululemon athletica. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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