Hope Springs Eternal for Amazon.com Investors

Most Wall Street analysts will readily admit that Amazon.com (NASDAQ: AMZN  ) is one of the hardest stocks to value. The company has consistently posted rapid sales growth; revenue jumped from just $5.3 billion in 2003 to nearly $75 billion last year. Yet earnings growth has been extremely volatile. Indeed, Amazon's 2013 EPS was more than 75% below the all-time high from a few years ago.

AMZN EPS Diluted (TTM) Chart

AMZN Diluted EPS (TTM), data by YCharts.

The disconnect between strong revenue growth and weak earnings is driven by Amazon's heavy growth investments. This earnings volatility forces analysts and investors to undertake a lot of guesswork to determine the company's "true" value.

Most of these analyses skew bullish; a recent valuation analysis by Bernstein Research is a case in point. However, investors' optimism stems from overly rosy thinking. Other very plausible scenarios that could lead to much lower valuations for Amazon are simply ignored.

(Over)valuing Amazon
Last week, Carlos Kirjner of Bernstein Research, a big Amazon bull, acknowledged some of the difficulties in valuing Amazon. He noted that the company's revenue mix has been rapidly shifting due to the growth of the third-party marketplace business and the Amazon Web Services cloud computing business.

Kirjner ran a series of valuation analyses in order to attack the problem of valuing Amazon from multiple perspectives. These analyses placed Amazon's fair value as high as $571 a share, more than 50% above the market price. Even the most "conservative" of his scenarios puts fair value at $451 per share.

A Bernstein Research report put Amazon's fair value as much as 50% ahead of the current price.

There are two main reasons that Kirjner's analysis comes out so rosy. In some scenarios, he uses "historical multiples" for Amazon. This unwisely projects past growth rates into the future. In other scenarios, Kirjner applies sales multiples from other businesses with much higher-margin structures. This unwisely assumes that Amazon can ultimately replicate these other companies' profit margins.

Not your father's Amazon
The danger of using historical multiples stems from the torrid growth Amazon has experienced up to this point, combined with the law of large numbers, which will restrict growth going forward.

AMZN Revenue (TTM) Chart

AMZN Revenue (TTM), data by YCharts.

The chart above shows that Amazon's revenue has risen by about 1,200% in the last 10 years. (EBITDA, a measure of profitability, has also risen by a similar amount in the last 10 years.) If Amazon repeated this performance in the next 10 years, revenue would hit roughly $1 trillion by 2023. Even the most enthusiastic Amazon bulls recognize that revenue will not grow nearly this quickly.

If Amazon grows half as quickly over the next 10 years as it did over the last 10 years, then using a historical multiple is inappropriate. Amazon investors 10 years ago could look forward to a lot more growth (in percentage terms) than present-day Amazon investors. All else being equal, Amazon should perhaps trade at half of its historical multiples today.

Looking for better comparisons
Kirjner ultimately tried to estimate Amazon's value by comparing each of its three main business lines (first-party retail, third-party retail/fulfillment, and Amazon Web Services) to their competitors. He then applied price-to-sales ratios from these competitors to his sales estimates for each Amazon business line.

This analysis assumes that the businesses being compared have similar margin profiles and future growth prospects. However, while Amazon has better growth prospects than many of the companies Kirjner uses for comparison purposes, it also has a much lower-margin profile. These two factors could theoretically cancel each other out, but on balance the price-to-sales comparisons seem to inflate Amazon's value.

For example, in the first-party retail business, Kirjner compares Amazon to the S&P 1500 retail index. This index includes fashion retailers that can reliably earn double-digit pre-tax margins. By contrast, Amazon's main selling point is that it offers the best prices on widely available products.

Costco is perhaps the best comparison for Amazon's business today.

In this sense, the best comparison for Amazon might be Costco (NASDAQ: COST  ) , which also attempts to drive high sales volume through very low prices. Costco's sales are growing at a healthy high-single-digit rate (still not nearly as quickly as Amazon's retail sales). However, Costco's operating margin has hovered around 3% recently, justifying a low multiple of 0.5 times sales.

Amazon's operating margin has been lower than that of Costco for several years now. However, Amazon has previously achieved an operating margin above 6%. Amazon bulls think that in the long run, Amazon will return to or even exceed its historical margins.

AMZN Operating Margin (TTM) Chart

AMZN Operating Margin (TTM), data by YCharts.

The idea that Amazon will return to its 2004 or 2005 margin level is wishful thinking, though. Amazon's business has completely changed since then. In 2005, media still accounted for more than two-thirds of Amazon's revenue. Today, media represents less than one-third of Amazon's revenue, and it is growing more slowly than Amazon's other product lines.

The rise of the "electronics and general merchandise" category -- where Amazon competes on price with other mass retailers -- has led to a permanent change in its retail margin structure. To be sure, Amazon's operating margin is artificially compressed at 1%. However, there is no fundamental reason to expect retail margins to return to levels that were achievable when its main competitor was Barnes & Noble.

Foolish wrap-up
Similar comparison problems may exist for Amazon's other business lines. The broader point is that it's dangerous to value businesses by analogy when there isn't a good analogy to use. (As I acknowledged earlier, my Costco analogy is imperfect because Costco is not growing as quickly as Amazon.)

A better way of valuing Amazon would be to estimate its earnings or cash flow a few years from now (when the company's current investments should be paying dividends) and then discount back to present value.

That's not a straightforward exercise, either. However, it would force Amazon bulls (and bears) to directly spell out their long-term growth and margin assumptions. This would make it a lot easier for investors to evaluate the credibility of various valuation scenarios.

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Read/Post Comments (12) | Recommend This Article (12)

Comments from our Foolish Readers

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 March 18, 2014, at 6:09 PM, Mega wrote:

    Very good article Adam.

    You're braver than I am, shorting AMZN.

  • Report this Comment On March 18, 2014, at 8:31 PM, erich69 wrote:

    Very brave indeed! The problem with shorting stocks like this is that they are psychologically driven and have broken off from rational investing based on fundamentals...Certainly a small cap can get away with such ridiculous valuations because of room for growth, but AMZN is a $180B market cap...with limited upside due to the law of large numbers I wouldn't get in this late in the game...this stock is driven by faith in the visionary Bezos not from showing strength of profits. If he is no longer CEO, I would be terrified as a shareholder. Short sellers are usually right in the long run, but often their pockets do not run deep enough to stay in the game to outlast the psychology of the masses, be very careful as you are in the minority as an AMZN bear...I will avoid taking either side with this investment

  • Report this Comment On March 19, 2014, at 8:21 AM, XXF wrote:

    While I agree that Amazon's fundamentals do not support the current stock price it isn't a stock I'd be willing to short. Remember that in investing being right at the wrong time is the same as just being wrong, and I see nothing to suggest the consensus exceptional valuation of Amazon's fundamentals will change anytime soon. Good luck.

  • Report this Comment On March 19, 2014, at 4:33 PM, pondee619 wrote:

    My difficulty with Amazon is, there is only one reason to buy anything from Amazon, TOTAL COST (price plus shipping). Maybe the convenience of being able to shop whlie in your jammies.

    However, total cost is the real draw and any retailer who depends on cheap prices to keep sales growing can't raise prices to improve margins.

    Cost P/S 0.46

    WMT P/S 0.51

    AMZN P/S 2.34

    COST OpMargin 2.84%

    WMT OpMargin 5.64%

    AMZN OpMargin 1.00%

    So with Amazon I'm paying 4.5 times more than COST and WMT on a price to sales basis and getting a third (COST) to a fifth(WMT) for each sale.

    While I wouldn'd short AMZN, the market here seems nuts, I can't see buying it at this price with little prospect of increasing profit margins. And if AMZN raises profit margins, it is just another retailer.

    Is revenue gtrowth without earnings growth a good investment? At what point will the market start demanding a profit from AMZN?

  • Report this Comment On March 20, 2014, at 2:52 PM, TMFGemHunter wrote:

    Thanks for the comments everybody!

    @pondee619: That's the $64,000 question. I think as revenue growth drops below 20%, investors will become more and more earnings-focused. But that's just my best guess.

    Adam

  • Report this Comment On March 20, 2014, at 5:02 PM, Nixic wrote:

    I'm not an investor by any measure but I am a fan of Amazon and I recently subscribed for Amazon Prime with no regrets. I may fit into a niche group of people but Amazon has it right for me personally. I love Amazon's shopping platform and with free two-day shipping its a steal. The video service is actually quite nice for a millennial like me where 100% of the content I'm interested in is web based. I can switch from shopping, to Youtube, to Amazon, and between another 100 websites I'd rather be on instead of pre-programmed garbage. Then there is the Kindle books offering which I'll utilize somehow, someday. IMO web-based services have a lot more growth and I think the cable companies will eventually be dropped entirely. I can't even find a reason to justify a subscription to Time Warner beyond ethernet connectivity.. Just my two cents.

    Ryan, 24 Temecula, CA

  • Report this Comment On March 20, 2014, at 6:01 PM, DukeMontrose wrote:

    Well before Christmas the way I was treated with the submission of my magnum opus, some call a Central-European "Gone with the Wind' I was a wee bit blown away

    (can you be blown away a 'wee bit'?).

    Went through the usual fandango = not only missed the Christmas season but did not get published at all.

    Possibly as a 90 year young holocaust survivor i am not as tech savvy as most Fools.

    But I can say with absolute authority: Margaret Mitchell's epic would not have been published either, in our super electronic age.

    Then I looked up AMZN's PER = over 620X, this fool was indeed blown away - being a veteran investor in the Sir John Templeton mold.

    Now I know what irrational exuberance is.

    This fool plunked down a few thou on a very few put contracts foolishly believing I'll begin to make up my "losses' on my unpublished opus.

  • Report this Comment On March 20, 2014, at 6:41 PM, DukeMontrose wrote:

    This is a foolish PS to previous post.

    Just for fun I looked up what AMZN actually earned in 2013. Believe me it was not easy as most entries dismissed them as irrelevant (sic!) to this stock.

    The best # I could find is $274 million.

    Now "Gone with the Wind" sold 30 million copies plus at least 200 million movie tickets.

    Could my foolish opus do as well? Of course not. But if it would equal Margaret Mitchell's, did Bezos throw away a chance to double 2013 AMZN's profits by not publishing mine???

    Pardon my foolish musings...

  • Report this Comment On March 20, 2014, at 6:42 PM, mamarazednofool wrote:

    Great article, and lots of food for thought. However, as a dedicated Amazon investor, I think it is pure folly to assume that the law of big numbers will restrict Amazon's growth any time soon. I am confident that Mr. Bezos has plans to hit $1 Trillion in revenue mark in stride and not even slow down to notice. He may have a year or two with marginal growth, and then he will find a way to double or triple growth in a few years with a major new business line. I also believe comparing Amazon to any other company, in any way (revenue growth, operating margin, or number of pencils per employee) is pretty meaningless. There is no other company out there even remotely like them. Some would call it "Hope", but I call it "Faith", and there is a world of difference between those two words when it comes to investing. I hope the world will learn to live in peace. I have faith that Amazon will dominate online retail for the next 50 years.

    - MamaRazedNoFool

  • Report this Comment On March 20, 2014, at 11:09 PM, somethingnew wrote:

    I think Amazon is one of the few companies in history where from inception in the early 90's up until now, metrics never truly apply to it's stock. They do in the most technical sense when it comes to anybody and everybody trying to value it, otherwise you can throw valuation out the window in retrospect. IMO you can't do that with any other public company in retrospect. There is not a single company out there that I know of where it has gone 20 years and valuation (PE, PS, Roe, etc), at least from a non-technical perspective, never really mattered. It's also the only company that I know of that makes Benjamin Graham's famous quote "since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine" look illogical since Amzn has always been more of a voting machine based on valuation ratios. I think 20 years can be considered fairly long term. I'm not saying it's a good or bad value based on today's prices. I'm just saying with any other company you could look back at the previous 20 years and in hindsight see a pattern other than rapid growth justify it's stock price.

  • Report this Comment On March 20, 2014, at 11:14 PM, somethingnew wrote:

    Looking at what I just wrote, Roe would be incorrect since that did matter but it would have not mattered for earnings since the majority of it gets pumped back into revenue in one way or another.

  • Report this Comment On March 25, 2014, at 8:55 AM, mispoken wrote:

    I just love Amazon. But I dont know how they do it. I had a fender bender last Friday and I found a new bumper, bumper brackets and air dam on Amazon for dirt cheap with free 2 day shipping (prime member). The bumper came in a huge box Monday, it was basically overnight shipping. I dont know how they do it, but that alone paid for the prime membership I think. Its just a practical example of how thin their margins must be.

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