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Friday, November 27, 1998

An Investment Opinion
by Warren Gump

"Guessing" Amazon's Value

In last Friday's FOTH, I discussed the parameters involved in creating a discount earnings model for a hypothetical Internet bookseller. The response to the article was loud and clear: Thanks for the interesting article, but how does your model apply to (Nasdaq: AMZN)? To be honest, I used an imaginary company because it was my own creation, making it much harder for others to argue about various assumptions. You, our Foolish readers, have (correctly) indicated it is very unFoolish to hide behind this wall of fictional numbers.

Before going forward with calculations on the real company, let me bombard you with disclaimers. This work is just a guess as to what the theoretical value of would be if certain assumptions play out. The assumptions are not based on my expectations for the future, rather they are designed to illustrate what the discounted value of Amazon's earnings would be under certain situations. I have not closely monitored Amazon in the past and do not know where its sales and expense line items will move in the future. This exercise is simply a finance-oriented guy trying to see what kind of future the market is pricing into Amazon's stock. Stocks in general, and Amazon's stock in particular, often trade at levels that are far different from the value spit out by any model.

This analysis is based on the assumption that reported earnings approximate cash flows, which is the real number that should be used to calculate the present value of a company. For the sake of simplicity, however, I am making the two equivalent. In reality, this assumption is often invalid.

I have no position in stock or options. One of The Motley Fool's real-money portfolios, the Fool Portfolio (soon to be renamed the Rule Breaker Portfolio), does hold a long position in Amazon. You can go to that portfolio's archives to read the reasons why it is invested in the stock.

The Model
I consider the "base case" of this model extraordinarily, if not ridiculously, ambitious. The assumptions associated with it were created in an attempt to obtain a present value of operating earnings that approximates the current stock price (as of Tuesday). While this may seem like reverse logic to many people, it provides an indication of what kind of future is priced into the stock. The actual value spit out by the model with these assumptions is $208.36. (Note: See below for information on how to access the model spreadsheet.)

To give you some indication of how aggressive these assumptions are, this model produces year 2000 tax-adjusted operating earnings of $1.26 per share. First Call's consensus estimate on Amazon for the same year is a loss of $0.43 per share. Looking out into 2001 and 2002, the model shows EPS of $7.31 and $17.51, respectively. This kind of profit growth would be absolutely astounding.

What does Amazon look like at various stages of this model? Next year, the company would have sales of $2.6 billion. By 2001, revenues would be $11.5 billion. Going out to 2008, the company would be selling $70.8 billion in merchandise. That puts sales for Amazon ten years from now greater than the combined 1998 results of Kmart (NYSE: KM) and Dayton-Hudson (NYSE: DH), the owner of Target. This rapid growth would have to occur while the company maintains margins of 23%, which is slightly higher than what it reported in the first nine months of this year. Simultaneously, expenses would have to be leveraged dramatically, falling from 25.7% of sales in 1999 to 9.0% of sales in 2008. Delivering on this kind of model would almost certainly have to be the greatest business success in history.

The value spit out by this model varies dramatically based on changes to the underlying assumptions. To get an idea of the sensitivity to changes in various assumptions, a thumbnail sensitivity analysis is provided beneath the listing of base case assumptions. Note that the sensitivities listed are based on changing only one variable at a time. In real life, all of the input variables will be changing simultaneously.

Reducing the discount rate below 25% would enable the creation of projections less preposterous than the ones I've created and still justify the recent price. I didn't feel comfortable doing that, however, because it seems to me that investors in this volatile stock are going to expect returns of at least that amount.

One interesting bit of trivia that indicates the importance of what happens over the long term: In this model, 85% of Amazon's present value is created by results beyond the year 2004!

On to the numbers!

Base Case Assumptions
Discount Rate (the annual return shareholders expect): 25%
Long-term growth rate (year 2009 and beyond): 15%

The assumptions below are listed for the following time periods:
Q4:98, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008

Revenue Growth: 500%, 250%, 150%, 75%, 50%, 40%, 30%, 25%, 25%, 20%, 20%.

Gross Margin: 23% for all periods (it was 22.5% for the first nine months of 1998).

Total Expenses (including marketing, product development, and general and administrative): 26.1%, 25.7%, 21.2%, 17.0%, 13.4%, 11.4%, 9.9%, 9.0%, 9.0%, 9.0%, 9.0%.

Taxes: A flat 35% for all periods.

Share count: Flat at 61.8 million throughout. Based on 52.8 million shares outstanding on 10/31/97, plus 9mm shares from options that were outstanding on 12/31/97.

Revenue Growth Sensitivity:
What happens if we change revenue growth a little bit. Let's say that we change the revenue growth in 1999 to 150% instead of 250%. Out slips 29% of the value, to $148.77 per share.

Perhaps the model is too conservative. Maybe revenue will grow at a rate higher than 250%. If revenue were to grow 400% in 1999 (meaning sales of $3.8 billion), Amazon's value would jump 43% to $297.74 per share.

Gross Margin Sensitivity:
My original model assumes margins of 23%. Is that realistic? We'll see. Many people would argue that margins are likely to compress in the future as competition intensifies.

Here's the impact of various margin levels on this model:
18%: $126.10 (-39%)
20%: $158.02 (-24%)
22%: $191.58 (- 8%)
24%: $223.51 (+7%)
26%: $257.06 (+23%)

Expense Level Sensitivity:
Expense levels have been modeled to be dramatically lower in future years, indicating that Amazon will significantly leverage its marketing and other expenses. Below is the result of altering the expense levels for each estimated time period by the specified number of percentage points.

+7 percentage points (stabilized expenses at 16% of sales): $94.17 (-55%)
+3 percentage points (stabilized expenses at 12% of sales):$159.65 (-23%)
-3 percentage points (stabilized expenses at 6% of sales):$258.69 (+24%)

Tax Sensitivity:
Changes to the tax rate will also affect the valuation.

+5 percentage points (tax rate of 40%): $192.32 (-8%)
-5 percentage points (tax rate of 30%): $224.39 (+8%)

Share Count Sensitivity:
No changes to share count (beyond options that were outstanding at the end of 1997) were made to our model. This assumption seems very conservative since options on 9 million shares were issued between the time the company was founded in 1994 and the end of 1997. Altering this assumption to one where the average number of shares outstanding (based on the treasury method) is increased by 1 million shares annually between 1999 and 2008, the discounted value of earnings would fall 13% to $182.32 per share.

Discount Rates Sensitivity:
Changing the annual return required by investors dramatically alters Amazon's value. Here are the results of discount rates other than 25% on the model.

18%: $885.28 (+325%)
22%: $329.27 (+58%)
28%: $145.50 (-30%)
30%: $118.49 (-43%)

Growth Rate Sensitivity:
The earnings growth rate beyond 2008 has a large noticeable impact on valuation. The default rate is 15% per year. While you may be inclined to increase this number, remember that this growth is occurring off a revenue base of $70.8 billion in 2008. Growth more rapid than 15% annually would be extremely impressive.

10%: $161.60 (-22%)
12%: $175.98 (-15%)
14%: $195.60 (-6%)
16%: $223.95 (+7%)
18%: $268.48 (+29%)

You're still here? I didn't lose you through all those numbers, eh? Perhaps you are a number cruncher who wants to do your own manipulation of numbers with this model. You are welcome to download it, but I have to admit it's not the most user friendly item in the world. If you don't have a finance background, you will probably be dazed and confused looking at it. Feel free to take a gander, but be forewarned. To download the model spreadsheet in Excel, click here.

Based on the number of responses to my last Internet "Fool on the Hill," it is highly unlikely that I'll be able to answer all the individual questions about this spreadsheet. If you have any inquiries, post them to the Web-based Amazon message board and I'll try to answer them. Unfortunately, I won't be able to respond to the boards until Monday afternoon/evening. And don't forget that each post to the Fool message boards between now and the end of the year will result in The Motley Fool donating 2 cents to Share Our Strength. Click here to learn more about this charity, or go here to make your own contribution now!

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