Amazon (AMZN 0.58%) is a leader in the two enormous growth markets of e-commerce and cloud computing, and that's helped the company's market value and earnings soar over the years. But to stay ahead in these competitive fields, Amazon has spent a bundle. In fact, just last year, the company increased its research and development (R&D) investment by 30% to more than $73 billion.
This information, on its own, shouldn't prompt us to run out and buy Amazon shares though. It's important to take a closer look at Amazon's financial situation to determine whether the company truly is making the right choices and benefiting from its investments -- and whether its growth strategy is sustainable.
And here, two key measures -- return on invested capital (ROIC) and weighted average cost of capital (WACC) -- may look worrisome at the moment. So, it's time to ask this question: Is Amazon investing too much in growth? Let's find out.
Smart investment decisions
ROIC tells us how much Amazon has profited from the investments it's made in its business. This metric is important because it helps us determine whether a company is making smart investment decisions -- ones that can boost earnings over time. WACC also is a metric to consider closely, as it measures how much it costs a company to finance its operations -- and financing is essential to support growth.
The chart below, using data from analytics firm New Constructs, shows Amazon's ROIC and WACC over the past five years along with a trailing-12-month (TTM) view for the most recent picture. As we can see, the company's ROIC has fallen, while its WACC has risen, since 2020. The TTM view shows some improvement in ROIC levels, but WACC continues to climb.
Image source: New Constructs.
If we examine ROIC and WACC, we can get an idea about whether a company is paying too much for growth. If we look at these particular numbers alone, that seems to be Amazon's case in recent times.
But it's important to take a look at other factors before getting worried about this market giant's investment strategy. First, let's consider ROIC. As mentioned above, Amazon increased its R&D investment last year, but this wasn't an isolated event. The company has been boosting this spending for years to maintain its strength in its core businesses of e-commerce and cloud computing as well as to enter new areas, such as healthcare.
Investment returns take time
Though these R&D investments are reported as an expense in a given year, the company doesn't immediately benefit from them. For example, last year Amazon increased spending in technology infrastructure by $10 billion to support growth of Amazon Web Services (AWS), but it won't reap the rewards overnight. It takes time to build AWS infrastructure and for that infrastructure to result in earnings growth.
It's also essential to consider the market and economic environment at a particular moment. Last year, higher inflation weighed on Amazon's costs and the ability of its customers to spend, and that hurt earnings. Amazon also doubled its fulfillment network in just two years then found itself with excess capacity as the economy soured.
At the same time, the company, taking a long-term view, continued to increase its investment in growth areas, such as AWS, as mentioned above, and potential growth drivers like artificial intelligence. And it made efforts to make its fulfillment system more efficient. All of this means ROIC may look low now, but Amazon should benefit from its investments at a later date.
And speaking of the economic environment, that offers us some insight into the WACC picture too. A higher interest-rate context, such as what we're experiencing now, increases the cost of financing for companies. The average WACC of companies climbed 50% from the start of 2022 through the end of the year, according to an article in Harvard Business Review. So, it's not surprising to see increases in Amazon's WACC today.
Amazon's efforts today
Now, let's get back to our question: Is Amazon spending too much on growth? The answer is simple: no. The retail and technology giant has cut costs in recent times, focused on efficiency, and favored investing in areas that should boost growth over the long haul.
We saw some fruits of these efforts in recent earnings reports, but it will take time for this to translate into an increase in ROIC. As for WACC, a potentially lower interest rate environment in the future could make capital more affordable for Amazon -- and other companies.
To stay ahead, Amazon must continue to invest and innovate even when times are tough, and the company has done so wisely. Amazon should benefit from all of its recent moves progressively, and that's great news for investors who plan on holding shares of this market giant for the long term.
