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eBay (NASDAQ:EBAY) and Overstock (NASDAQ:OSTK) are direct competitors in e-commerce, and both companies offer attractive potential for gains in the years ahead. However, there are some important differences between the two e-commerce players in areas such as fundamental quality and valuation. Which one should you place a bid for: eBay or Overstock?

Kicking the tires

Overstock is quite a volatile stock, trading as high as $24 and as low as $10 per share in the last year. At of the time of this writing, Overstock is trading in the area of $17.20 per share, so it's up by roughly 72% from its lows of the last year, but still trading 28% below its highs of the last 12 months. Price volatility can be a source of opportunity for investors when the fundamentals remain strong, but things are not so clear in Overstock's case.

Overstock buys excess inventory from brick-and-mortar companies to resell it online, and the company has been facing considerable challenges lately. Google changed its search algorithm in 2015, and this reduced traffic to Overstock. In addition, many traditional retailers are expanding their online presence, and Overstock is facing asphyxiating competitive pressure from bigger players such as eBay and Amazon (NASDAQ:AMZN)

Size is a crucial source of competitive advantage in e-commerce, since buyers and sellers attract each other to the biggest platforms in search for more business opportunities and better deals. A bigger platform provides a more valuable service, creating a self-sustaining virtuous cycle of growing size and increasing competitive strength.

Overstock is expected to generate $1.72 billion in sales this year, substantially lower than the $8.8 billion in revenue analysts are forecasting for eBay. As for Amazon, the industry giant is expected to generate a massive $134 billion in sales during 2016. 

Overstock hasn't been able to consolidate a strong competitive position in e-commerce, and its financial performance leaves much to be desired. Operating margins are low and volatile, and the company produced negative free cash flows during the 12-month period that ended in March of 2016.

OSTK Operating Margin (TTM) Chart

OSTK Operating Margin (TTM) data by YCharts.

eBay is a very different story. Not only is the company better established in competitive terms, the business model is also far more profitable. eBay provides a platform for buyers and sellers of all kinds of products to find a counterparty, and it makes a commission on every transaction. 

This means eBay doesn't need to worry about aspects such as inventory risks, and the company generates consistent profitability over time. eBay has produced positive free cash flows in every year over the last decade, and operating margin amounted to a healthy 28.7% of revenue in the first quarter of 2016.

Checking the price tag

Business quality and financial performance are of the utmost importance when making investment decisions, and eBay is clearly ahead of Overstock in these aspects. On the other hand, Overstock is substantially cheaper than eBay, and this can make a big difference in terms of potential returns going forward.

Since Overstock is producing volatile earnings and cash flows, it's hard to compare the two companies based on those metrics. However, when looking at price to sales ratios, Overstock trades at a compellingly low ratio of 0.25, while eBay carries a much higher price to sales ratio of around 3.24. 

Overstock is remarkably cheap, but that's not to say eBay is overvalued. Far from that, eBay is even attractively priced versus the broad market. According to data from Morningstar, eBay stock trades at a price-to-earnings ratio of around 15, while the average company in the S&P 500 index is in the area of 19.

From current price levels, Overstock offers massive room for gains if management can drive sustained profits going forward, but that's quite a big "if." Until, or unless, things turn for the better, Overstock will remain a remarkably risky proposition for investors.

Things look far clearer when it comes to eBay. The business is generating strong earnings, and the stock is priced at fairly reasonable levels. Simple investment ideas can often times be the most effective ones, and eBay looks well positioned for attractive returns going forward.

To sum up, eBay offers a solidly profitable business for a conveniently low valuation. Overstock is much cheaper than eBay in terms of sales, but the company hasn't yet proven its ability to turn those sales into consistent profits. All things considered, eBay looks like a sounder choice.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.