When you look at Amazon.com (AMZN 0.09%) as an investment opportunity, the stock often sends mixed messages. Amazon shares don't know how to stop rising, but the e-tailer's earnings are flimsy at best. So Amazon investors end up buying in at sky-high price-to-earnings ratios -- 250 times trailing earnings at the time of this writing.
Against that backdrop, it's easy to conclude that Amazon might be headed for an epic meltdown somewhere down the line. Icarus will eventually fly too close to the sun and come crashing back down to a more reasonable valuation.
But that's not where Amazon is going -- not at all. Let me show you how the company actually stands on firm financial footing and why the best is yet to come for this serial innovator.
Image source: Getty Images.
Cash flows, not earnings
Amazon has always been better at generating cash than producing net income. Sounds like splitting hairs, but it's a crucial difference.
Net income, also commonly known as earnings, is an accounting concept related to the calculation of tax payments. Starting from operating profits, you subtract items like interest expenses and corporate taxes, and there's the "E" in the popular P/E ratio.
By contrast, free cash flows are what's left of your company's operating income after cutting away non-cash adjustments such as deprecation, amortization, and changing levels of working capital. This value has nothing to do with tax obligations, but is a snapshot of the company's ability to move dollar bills all the way from the top-line revenue to the bank vault at the end of the quarter.
Most of the time, at least for companies like Amazon that don't have large and unpredictable capital expenses, free cash flows will be larger than net profits. If not, the company might want to find a new tax advisor. Most companies work hard to minimize their tax expenses, no matter how large their cash flows might be. I find it kind of funny that earnings and P/E ratios get all the headlines while cash flows are relegated to a much smaller role in most earnings reports.
Amazon happens to be very good at generating cash without sending large payments to Uncle Sam. In fiscal year 2016, the company reported $2.4 billion of net income based on $3.9 billion in pre-tax profits. On the cash flow statement, $16.4 billion of freshly collected operating cash yielded free cash flows of $9.7 billion. And that's generally how Amazon's finances work out, year after year:
AMZN Free Cash Flow (TTM) data by YCharts.
What to look for next
So the next time you see Amazon's net income landing in the red ink, or you're scratching your head over another crazy-high P/E ratio, remember that the company is making lots of money just outside the taxman's greedy reach. The bottom line will always be volatile by virtue of staying pretty close to the breakeven point.
But if Amazon ever starts burning actual cash, that would either prove that the company is up to new and expensive tricks or that the business model is falling apart. As seen in the rising cash flow line above, Amazon isn't throwing out any such red flags so far.
Nor do I expect that to happen in the foreseeable future. The Amazon Web Services suite of cloud computing tools is moving Amazon's financial foundation in the opposite direction, actually. The AWS division is now Amazon's largest generator of operating profits, setting the stage for a larger and more predictable net income trend.
Founder and CEO Jeff Bezos still runs Amazon like a hungry start-up company, still insisting that every day is "Day 1" for his company. Amazon may dominate the online shopping market and the cloud computing sector, but that's no more than 3% of the total American retail industry and a drop in the trillion-dollar ocean of enterprise computing on a global scale.
This giant has a lot of growing up left to do, starting from the fantastic cash machine you see today.
