Updated below to summarize the winners in Silicon Valley, and also to show how our analysis may not apply entirely to young companies

Anyone who thinks the stock valuation of Baidu, the newly public Chinese search engine company, is reasonable should consider the following:

We’ve mentioned before, when talking about Google, a stock is traditionally considered fairly valued if its price/earnings ratio is the same as the rate its earnings are growing. So a company with profits growing 100 percent a year would be fairly valued when its PE is 100.

It is true that Baidu is growing extraordinarily quickly. Baidu’s profits are growing about 140 percent annually, according to the latest data — much faster than Google. That’s to be expected for such a young company in such a fast-growing economy like China, where Internet usage is also exploding. Ok, so you’d expect a PE ratio of 140, or maybe 300 if you know those earnings are going to keep growing strongly, and people are just dying to own the stock.

But let’s do the math…(more)

First, check out Baidu’s market valuation. When we first looked Baidu’s stock price this morning, it was trading at \$146.90. Since Baidu has 32.5 million shares outstanding, you multiply that number by \$146.90 to get Baidu’s total market valuation, or total price. That’s \$4.77 billion. So to get the PE ratio, you divide price by its earnings. It is a bit tricky to know which number to take for Baidu’s earnings, because it had \$1.45 million in net profit last year. It had \$303,000 for the first quarter of this year — but if you annualize that, it is actually less than the \$1.45 million last year. Baidu must have had a bad first quarter or something, or maybe we’re misunderstanding something (see here for yourself, page 47 has the details). Anyway, let’s assume Baidu keeps growing at 140 percent, so that it reaches about \$4 million this year, compared to last year. This is means Baidu’s PE ratio is about 1,000 or so.

That is way out of line, and anyone betting on Baidu should buy a serious stock of aspirin — to prepare for the possibility of what will happen within six months from now.

Looks like Baidu’s stock has since slipped a bit over the last hour or two, but it is still above \$140 last time we check (our link may show otherwise in a few days).

Finally, keep in mind what happened to the other two recent big Chinese Internet successes, online gaming company Shanda Interactive Entertainment and 51Job. Shanda ended last year at \$42.50, but now trades around \$38. 51Job ended last year at \$55.35, but after missing its numbers and reported management issues, it has since dropped below its listing price of \$14. VentureWire has a story (sub req) on this.

Postscript: We forgot to mention the big Silicon Valley winners on Baidu: (1) Pat McGovern’s IDG, which has offices in San Francisco, but which McGovern took to China two decades ago, and (2) Draper Fisher Jurvetson, the Silicon Valley venture firm, which entered China with its ePlanet affiliate in 1999, beating most other Silicon Valley venture firms on the latest wave of firms seeking to invest there, and (3) Google.

In other words, this is a reward to venture capitalists who got there first, and spent time developing relationships. McGovern has been the most patient of all.

McGovern tells VentureWire that his firm’s 1.45 million shares in Baidu, bought for about \$1 a share, were worth roughly \$178 million after the IPO. But the DFJ fund is the biggest shareholder of Baidu, with a 25% stake now worth over a billion dollars. VentureWire says it is “unclear exactly how much DFJ put into Baidu, but the firm bought 8.19 million shares over the years at a fraction of the current share price.” (Update: Jeff Clavier has provided the details below in comments.)

Finally, Google took a 2.6% stake in Baidu last year.

Update: Michael Brush forwards his excellent critique of our analysis. The point is, PE works less well for younger companies:

When a company is young or “emerging,” it typically has minimal earnings compared to its potential. At this stage of a company’s development, p/e ratios are not meaningful.

Yes, you can say a company earned a penny and it trades for \$100 so it has an absurd p/e of 10,000. But p/e ratios like these in the early stages of a company’s development are irrelevant. The p/e may be high partly because the stock price is so high, but primarily because earnings are minimal since the company is still in the early stages.

It’s better at this point in a company’s life to use some other valuation measure like discounted cash flow (DCF), or some sort of comp analysis, ie. how much would this company go for, based on what similar companies sell for. I am sure the sell side walked through scenarios like these in the prospectus. I’m not saying Baidu is fairly valued — just that there are other ways to measure that which make more sense.