Amazon.com's Share Price Is Insane

The market, Wall Street analysts and my fellow Fools were tripping over themselves on Friday to gush over Amazon.com (Nasdaq: AMZN  ) after the company released earnings. A $0.28-per-share profit was quadruple what analysts had expected, and of course shares surged as a result.

After the 15% bump in share price on Friday, the stock trades at 170 times trailing earnings, an absolutely insane valuation in my eyes. Just how insane is it? I've put some numbers together to highlight just how much growth and profitability are already priced into the stock.

The infinite growth curve
Let's work backward into the valuation the market is already putting on the stock. I like to be able to see how a company can reach a P/E ratio of 10 sometime in the near future as a starting point. This is about the same P/E as Intel, Apple (Nasdaq: AAPL  ) , and Microsoft (Nasdaq: MSFT  ) when you take out their cash hoards, so it's also a reasonable valuation to use. If Amazon is going to reach a P/E of 10, the company will have to make $10.3 billion in profits. How could it get there?

I outlined three revenue levels Amazon would have to achieve to reach $10.3 billion in earnings with net margins of 2%, 4%, or 6%. The highest margin Amazon has ever recorded was 3.7% in 2009, and in recent history. margins have hovered around 3.5%, so the table gives us a pretty reasonable range to look at.

Metric

Low Margin

Medium Margin

High Margin

Revenue $515 billion $258 billion $172 billion
Net Margin 2% 4% 6%
Net Income $10.3 billion $10.3 billion $10.3 billion

In these cases, Amazon would have to reach revenue of $172 billion to $515 billion from a current revenue level of $51.4 million in the past 12 months. Since the argument nearly everyone is making is that Amazon is forgoing near-term profits for growth and long-term profits, the assumption would be that eventually the company will grow enough to live up to its current valuation. But if Amazon is ever to grow into its valuation, it's going to have to keep growing at an astronomical rate. Following are the annual growth rates Amazon would have to maintain to reach to revenue level above in five, 10, or 15 years.

Metric

Low Margin

Medium Margin

High Margin

5-Year Growth Rate 58.5% 38.1% 27.3%
10-Year Growth Rate 25.9% 17.5% 12.8%
15-Year Growth Rate 16.6% 11.4% 8.4%

If we assume, optimistically, that Amazon can reach a long-term net margin of 4%, it would grow into its current valuation in five years if it grew revenue at 38.1% a year, a level that's almost unheard of for a company this size (outside of Apple). It would reach that level in 10 years if it grows at 17.5% a year.

Remember that this is only to grow into its current valuation and doesn't assume any increase in the stock price or the number of shares outstanding over this time frame. Usually, investors would discount the stock price by an expected rate of return as well, meaning the actual growth the company will need to achieve to keep up with the market is higher than this.

Always low prices, and margins
Theoretically, Amazon could grow fast enough to grow into its valuation, especially if margins expand. The problem I have with the overall investment theory in Amazon is that the business doesn't operate in a fundamentally high-margin business. The opposite is true; it's in a low-margin business where competition will always be fierce.

Online retail is only worthwhile because it's cheaper than brick-and-mortar competitors. If Barnes & Noble (NYSE: BKS  ) offered the same selection at the same price as Amazon, I would shop there. The competition is also willing to cut prices to stay in the game. Overstock.com has a profit margin of -1.6% because it is trying to compete on cost, so Amazon has to keep up with these costs.

The streaming business Amazon is trying to get into will also have limitations when it comes to profitability. As Netflix (Nasdaq: NFLX  ) found out, content providers are demanding more and more for their content, and there is little barrier to creating their own distribution channels if they want to.

Then there's the Kindle business, which is attempting to enter into Apple's territory -- except Amazon has had to sell Kindles at a loss to enter the market and new devices are emerging using Google and Microsoft's operating systems. Today's announcement that Microsoft will invest in the Nook brings in more competition, making this an even tougher business for Amazon to capture.

I'm not seeing anything but low-margin businesses in Amazon's future. That's OK if the company can grow quickly, but if the record stops, so does the stock.

Betting on perfection
The bottom line is, Amazon will have to perform nearly flawlessly to live up to its current valuation. When stocks are priced for perfection, that's when disaster happens, and that's what I fear could be in Amazon's future. The list of companies that didn't live up to outrageous valuations is long, most recently including Netflix -- something I warned about as the stock peaked.

Even though I have doubts that Amazon can dominate the tablet market, we've identified companies that will profit from the technology revolution. Check out a report highlighting one winner.

Fool contributor Travis Hoiummanages an account that owns shares of Apple, Microsoft, and Intel. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings, or follow his CAPS picks at TMFFlushDraw.

The Motley Fool owns shares of Microsoft, Amazon.com, Intel, and Apple. Motley Fool newsletter serviceshave recommended buying shares of Microsoft, Apple, Netflix, Amazon.com, and Intel, creating bull call spread positions in Microsoft and Apple, and writing puts on Barnes & Noble. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (8) | Recommend This Article (13)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 01, 2012, at 12:23 AM, CaptainWidget wrote:

    Amazon will never be able to raise margins. It's a fundamental change in the business model that the market, and even Amazon's own operations, would likely not support.

    I love Amazon the business, but for their sake I hope that a mediocre earnings report doesn't come out the same week as a earthquake in Granite City, IL (or some other such psychological disaster in stock holder minds). That'll be the day the price drops to $75

  • Report this Comment On May 01, 2012, at 12:45 AM, millsbob wrote:

    "Online retail is only worthwhile because it's cheaper than brick-and-mortar competitors. If Barnes & Noble (NYSE: BKS) offered the same selection at the same price as Amazon, I would shop there."

    but the fact is that bricks&mortar operations Can't offer the same selection. and convenience of having things delivered rather than having to waste time foraging for them in person is more important to many of us than price, Travis.

    other than that, i agree with much of the article.

  • Report this Comment On May 01, 2012, at 2:52 AM, kakkineni wrote:

    Amazon is aiming to be the e-commerce platform, rather than just a retailer. On the B2B side, think of it as a credit card company with a fraction of the counterparty risk. Vendors sell products on the platform and likely use the more-efficient-than-UPS distribution/fulfillment network to get their products to customers quickly. Not only that, they take advantage of AWS to manage their sites and optimize the continually increasing data required to optimize customer demand.

    Shoot, they can even advertise on the company's emerging search/display platform.

    The B2C platform is merely a way to keep customers inundated into the brand. The first (and after visiting brick and mortar, often the last) place many consumers visit is Amazon. Why not encourage that pattern by providing streaming and other features? It only further encourages other vendors to sell on their e-commerce platform.

    1-3% in margins per year for 100 years is eminently possible if your goal is to skim a share of profits off of 25+% of all e-commerce sales. It's not possible if your goal is to simply be the best retailer.

    Given all of this, your comments regarding revenue requirements are moot.

  • Report this Comment On May 01, 2012, at 2:54 AM, gabeazy wrote:

    "Then there's the Kindle business, which is attempting to enter into Apple's territory -- except Amazon has had to sell Kindles at a loss to enter the market and new devices are emerging"

    Sell at a minor loss to generate an annual revenue stream (Amazon Prime subscript) + drive media sales (read: books - not low margin). I have no incentive to defend the stock. I'm short. But I just don't understand what motivates you guys to "contribute" on here. Do you have a words per article limit, or just really don't care enough to learn the business you're covering?

    Site's a joke.

  • Report this Comment On May 01, 2012, at 3:17 AM, CaptainWidget wrote:

    You don't NEED amazon prime if you own a kindle, it's just another feature, one that I'm sure many buyers do not take advantage of.

    I'm in the publishing industry. I can vouch that Amazon takes an EXTREMELY low margin on physical books. If you're talking E-Books, they just take a modestly low margin. In the majority of cases, the majority of the revenue of an E-Book sale is sent to the author.

  • Report this Comment On May 01, 2012, at 6:58 AM, adamj980 wrote:

    Great points people pay 150 times earnings for a company growing slower than apple at 10 times earnings. I am an amazon customer, but not going to be a shareholder at this valuation.

  • Report this Comment On May 01, 2012, at 12:02 PM, fikemj wrote:

    Everyone here realizes that PE is not the only valuation metric out there right? Not to say it's not over-valued anyway, but just for the sake of argument this article: http://www.fool.com/investing/general/2012/04/27/i-dont-beli... makes some interesting points...

  • Report this Comment On May 02, 2012, at 7:28 AM, saravanc wrote:

    Can anyone share some more insights on how this article derived the statement "Amazon has to make 10.3 billion in profits, to stand up with the current valuation" or it has to reach a PE of 10?.. I am trying to learn all these ... Thanks and much appreciate.

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