Regardless of whether you're a novice investor or one who's seen their fair share of recessions, the coronavirus disease 2019 (COVID-19) pandemic-induced stock market crash challenged investors' resolve like nothing before it. In less than five weeks, we watched more than a third of the S&P 500's value briefly wiped away.
But amid this chaos, and the subsequent rally that's been ongoing for much of the past three months from the March 23 bottom, a few companies have stood head-and-shoulders above the pack. Perhaps none more so than e-commerce giant Amazon (NASDAQ:AMZN).
Amazon has proved unstoppable this year, but is fundamentally pricey
Amazon may not have delivered the biggest percentage gains since the stock market bottomed out, but its performance in 2020 is pretty impressive, especially when you consider that it's the third-largest publicly traded company on the U.S. exchanges at $1.34 trillion. At no point in 2020 has Amazon's share price been down more than 9% on a year-to-date closing basis. What's more, the company's year-to-date gain (through June 29) of 45% represents a 50-percentage-point outperformance of the benchmark S&P 500.
Amazon has found itself as a (pardon the pun) prime beneficiary of the COVID-19 pandemic. With consumers unable to make it into brick-and-mortar stores due to nonessential business shutdowns or just general concern about spreading/catching the coronavirus, Amazon has found itself as the de facto beneficiary of a surge in online sales.
However, Amazon isn't cheap -- at least in the traditional sense of the term. According to Wall Street's consensus estimates, Amazon is valued at 142 times projected profits this year, and a whopping 72 times forecast earnings per share in 2021. Considering that Amazon's trailing 12-month operating margin is only 4.7%, this looks to be a hefty price to pay for the e-commerce giant.
Amazon could well become the first $3 trillion company
But that's just the thing; Amazon isn't anything like a traditional business. It, and the other FAANG stocks, reinvest a significant portion of their operating cash flow to grow their core operations, innovate, and branch off into new ventures. Thus, focusing on the stodgy price-to-earnings ratio has never been a particularly good way of valuing Amazon, because maximizing profits in the present won't help it grow for the future. Instead, price-to-operating cash flow serves as a much better bar when trying to determine a fair valuation for a highflier like Amazon.
According to Wall Street estimates, Amazon is set to generate an insane amount of operating cash flow in the years to come. The consensus on a per-share basis calls for:
- 2020: $85.73
- 2021: $106.80
- 2022: $126.50
- 2023: $201.30
What makes this nearly parabolic operating cash flow growth over the next couple of years so intriguing is that Amazon has ended each of the past 10 years at a valuation of 23 times operating cash flow on the low end to 37 times operating cash flow on the high end. That's a median valuation of roughly 30 times operating cash flow. If Amazon were to hold this median valuation of 30 times operating cash flow by the end of 2023, it would have a $6,039 share price and sport a market cap of (drum roll) $3.01 trillion.
The math might sound crazy, but Amazon simply has to trade within its historic premium range to become the stock market's first $3 trillion company -- and it can all be done within the next four years.
What's driving Amazon's growth?
As you can imagine, much of Amazon's branding and initial engagement is derived from its marketplace. Depending on your preferred source, this is a company that controls in the neighborhood of 40% of all U.S. e-commerce. Amazon has completely changed the game for the retail industry by reducing overhead and rethinking convenience and logistics.
Though retail margins are typically razor thin, Amazon has been able to use its Prime memberships to drive growth. The company announced earlier this year that it had crossed 150 million Prime members worldwide, and is more than likely nearing 200 million with the ongoing pandemic. Not only do Prime memberships generate higher-margin revenue that Amazon can use to reinvest in its logistics and undercut brick-and-mortar retailers on price, but it's the perfect tool to keep users within its product and service ecosystem.
But let's be real -- the bulk of the company's operating cash flow growth is going to come from its cloud infrastructure-as-a-service segment, Amazon Web Services (AWS). We were already witnessing a steady transition for businesses into the digital realm far before COVID-19 rocked the world. Now, that transition has been sped up considerably, and it's AWS that'll provide the building blocks for small and medium-sized businesses to develop their clouds.
The thing about cloud revenue is that it generates substantially juicier margins than Amazon receives from e-commerce, grocery sales, ad revenue, and streaming content. Put in another context, as AWS grows into a larger percentage of total sales, the company will see an exponentially greater increase in its cash flow. Since the end of 2018, AWS has grown from 11% of total sales to 13.5% of Amazon's revenue. By the end of 2023, it's quite possible that we could see more than 20% of Amazon's revenue generated by AWS.
The next time Amazon's nearly $2,700 share price or price-to-earnings ratio scares you, remember this company's cash flow potential. It's truly game-changing, and it could well make Amazon the largest publicly traded company in the world.