Amazon (AMZN 1.04%) has been a significant winner over the last two decades, generating enormous wealth for its investors.
But for investors who have yet to buy the stock, is it too late now to add Amazon to their portfolio? Here are three questions to ask to answer that question: Is it a good business? Does it have good prospects? And is the stock price attractive?
Is Amazon a good business?
There are many ways for investors to evaluate a company's business model. Here are two elements to assess: customer captivity and barriers to entry.
Customer captivity relates to the degree to which customers are loyal to a particular company or brand, making it difficult for them to switch to competitors. For Amazon, its customer captivity is reasonably high for several reasons.
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Take e-commerce, for example. Amazon is the largest e-commerce platform in the U.S., offering the most extensive selection of products at attractive prices. This makes it easy for customers to find almost anything (at attractive prices) on Amazon without using a second platform. Besides, Amazon's extensive delivery network makes it very convenient (and fast) for customers to receive their orders. Customers in metro areas can receive a broad range of items the same day they order them.
Layering on top of all the above is Amazon's Prime membership, which allows customers to pay a reasonably affordable fee and get a wide range of benefits, such as free delivery, streaming services, exclusive deals, and other perks. With more benefits added over time to Prime, customers have no reason to change their online shopping provider, especially once they have built the habit of shopping on Amazon.
The next aspect is to assess the barrier to entry for competitors to grab market share from Amazon. Here again, Amazon scores well for several reasons. For example, Amazon is the largest e-commerce platform in the U.S. (with 37.6% market share), giving it an enormous scale advantage over its competitors and new entrants. This scale advantage allows Amazon to get very attractive prices from purchasing and operate at the lowest unit operating cost (thanks to operating leverage), which helps it maintain its low-price strategy.
Besides, Amazon's massive investment in infrastructure and technology over the years -- in operations, logistics, and others -- helps it provide one of the best (if not the best) online shopping experiences. Recreating such an infrastructure would take competitors years (if not decades) and colossal capital.
In short, Amazon's high customer captivity and enormous barrier to entry position it as the dominant e-commerce platform in its key markets, one that's difficult for anyone to replace.
What are Amazon's prospects for the coming years?
Amazon has been an outstanding growth stock in the past, but that will not be useful to new investors unless it continues to grow. The good news is that there are good reasons to be optimistic about Amazon's prospects in the next few years.
Let's start with cloud computing, Amazon's other major business after e-commerce. Amazon Web Services (AWS) has a 31% market share worldwide in the cloud infrastructure market. Like its e-commerce sibling, AWS enjoys a scale advantage, which it passes on to customers at low prices. It's difficult for newcomers to offer the breadth of services at prices low enough to lure away customers, mainly due to the high switching costs of changing providers. Still, there is a competition risk from existing tech giants -- like Microsoft and Alphabet --that will grow their market share over time at the expense of Amazon since these companies are also actively growing their cloud businesses. However, given the vast tailwinds ahead, which include the ongoing migration to the cloud and the development of artificial intelligence (AI), there are enough growth opportunities for multiple players to flourish.
Similarly, Amazon's e-commerce business still has a long way to go despite its significant online market share since its total market share in the U.S. retail market is less than 10%. It can rely on the ongoing increase in e-commerce penetration and offline store expansion to grow its retail market share in the long run. Besides, it can depend on overseas expansion in emerging markets like India to keep its growth machine spinning.
In other words, Amazon (despite its huge size) can continue to grow in the foreseeable future.
Can investors buy the stock at a reasonable price?
An investment analysis is never complete until investors consider the stock's valuation. The focus here is to ensure they are not overpaying for a stock, regardless of the quality of its underlying business.
While endless valuation tools are available, investors can opt for simple metrics. The idea is just to be roughly right rather than be precisely wrong. For example, using simple ratios like the price-to-sales (PS) ratio shows that Amazon's current PS ratio of 3.4 is around the average level for the last five years. That ratio reached a low of 1.7 and a high of 5.6 in the previous five years.
So buying Amazon's stock today, while it doesn't provide any discount to investors, is probably still acceptable considering its business's quality and ongoing prospects.
Investors with strong conviction and a long-term horizon (of at least three years) can consider adding Amazon's stock to their portfolio.
