Risk Report Card: Amazon.com

"Rule No. 1 is never lose money. Rule No. 2 is never forget rule number one."

No, that's not Brad Pitt from Fight Club -- that's Warren Buffett explaining the most important rule in investing. It's what separates investors from speculators, and professionals from the merely lucky. But it's not easy. As Seth Klarman says, "It can be hard to concentrate on potential losses while others are greedily reaching for gains ... yet the avoidance of loss is the surest way to ensure a profitable outcome."

So how do we do it?

Step 1: Assess the Risk Factors
Like snowflakes and cheese balls, no two companies are exactly alike, but a look at common risk factors is a good way to cover our bases. Amazon.com (Nasdaq: AMZN  ) is an excellent online retailer. But what about the risks?

  1. Profitability: Companies that are making money, as opposed to losing it, are less likely to fail or wither away. (You'd be surprised how many people forget this.)

Metric

As % of Revenue

Risky? (1-lowest to 5-highest)

Net Income Margin

4%

1.0

Free Cash Flow Margin

5%

1.0

Retailing kingpins Wal-Mart (NYSE: WMT  ) and Costco (Nasdaq: COST  ) sport net margins of 3.5% and 1.6%, respectively. Amazon's hitting almost 4% is nothing short of incredible in this incredibly competitive industry. It's free cash flow margin is even higher, which means that not only is it turning an accounting profit, it's also bringing in actual cash-moneys.

  1. Diversification: You don't want all your eggs in one basket. Especially if that basket is flammable.

Metric

Description

Risky? (1 to 5)

Customers

Diversified customer base

1.0

Suppliers

Diversified vendor base

1.0

As not just a traditional retailer, but a retailing platform, Amazon sells to millions of customers and gets inventory from a very broad number of suppliers.

  1. Debt: Someone once said that debt was a lot like gasoline: You don't want to be carrying it if you're afraid of catching on fire.

Metric

Value

Risky? (1 to 5)

Interest Coverage Ratio

47x

1.0

Debt-to-Capital Ratio

2%

1.0

Cash-to-Debt Ratio

39x

1.0

Debt-to-Free Cash Flow Ratio

10%

1.0

Amazon has an absolutely miniscule amount of debt. Not only does its existing cash hoard completely dwarf its $132 million debt load, the company actually generated over 10 times as much in free cash flow, $1.5 billion, just last year.

  1. Valuation: "Price is what you pay; value is what you get." -- Ben Graham.

Metric

Multiple

Risky? (1-5)

P/E

52x

5.0

P/FCF

32x

4.0

PEG Ratio

1.3x

2.0

Relative valuation multiples certainly don't make Amazon look cheap, but when compared against its historical growth, the company's current price doesn't seem as outrageous.

  1. Opportunity Cost: While it's difficult to really give a grade here (and thus why there is none), it's important to remember that investment decisions aren't made in a vacuum. A company's risk profile must be considered relative to its competitors and other opportunities like it.

Company

Market Capitalization ($mm)

Net Income Margin

Debt/Capital

P/FCF

Costco

    24,569

2%

17%

15x

eBay (Nasdaq: EBAY  )

    27,673

28%

0%

27x

Target (NYSE: TGT  )

    38,215

4%

50%

10x

Wal-Mart

   191,678

4%

41%

16x

Amazon's business model really shines in this comparison. Being an online-only retailer allows it to stay away from the debt you see traditional players like Target and Wal-Mart loading up on.

Step 2: Tally and Score

Weighting

Category

Final Grade

20%

Profitability

1.0

20%

Diversification

1.0

40%

Debt

1.0

20%

Valuation

3.7

100%

Total Score

1.5

 

Final Grade

A

What's really interesting about Amazon's score here is that it turns the traditional notions about technology-based companies on their head. David Gardner, one of The Motley Fool's co-founders, has often said that his favorite businesses aren't necessarily those that sell technology, but instead those that use it to create a sustainable moat around themselves. Amazon's ability to generate high margins and a lot of cash flow while using less debt than its physically restrained counterparts actually makes it less prone to any unforeseen catastrophes.

Step 3: Learn More
We've covered a lot here, but no system is every going to be complete. Macro trends in the general economy as well as the industry specifically, management effectiveness and their history acting as responsible stewards of shareholder capital, and the general competitive landscape in which a company operates are all potential cracks in the hull.

At the end of the day, the biggest risk is you, the investor; because over time, apathy and ignorance will destroy any investment thesis. Fortunately, that's one risk you can control. Investors know what they're getting into; speculators get lucky. Learn more about Amazon.com here: Stock Cheat Sheet: Amazon.com.

Motley Fool Rule Breakers analyst Sean Sun owns shares in Amazon.com. Costco Wholesale and Wal-Mart Stores are Motley Fool Inside Value recommendations. Amazon.com, Costco Wholesale, and eBay are Motley Fool Stock Advisorselections. Motley Fool Options has recommended a bull call spread position on eBay. The Fool owns shares of Costco Wholesale. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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