Solving the Mystery of Amazon’s Valuation

Many people consider Amazon.com (AMZN -1.65%) to be extremely overvalued. And looking at standard valuation metrics like the price to earnings ratio, it's hard to disagree: Amazon's trailing P/E ratio is a whopping 1399, and a still very high forward P/E ratio of 144. But how does Amazon compare to other retailers?

Sizing up the competition
Let's take a look at eBay (EBAY 0.31%) and Wal-Mart (WMT 0.57%). eBay is Amazon's main online competitor, while Wal-Mart is the king of offline retail.

Amazon is the most expensive of the three stocks on price-to-earnings, while eBay leads price-to-sales with a ratio of 4.3.

eBay and Wal-Mart are polar opposites: eBay doesn't have any physical stores and doesn't sell any of its own goods, while Wal-Mart has a huge physical footprint and sells the vast majority of its goods through those stores.

Amazon is actually in between these two extremes. It sells its own goods via its own website and uses its own warehouses to store them. But it also allows other sellers, called third party sellers, to sell their goods on Amazon's website, just as eBay provides a platform to a variety of businesses to sell their own goods.

In fact, it's estimated by Scott Wingo of ChannelAdvisor that Amazon's third party selling platform (3P) now has a higher gross merchandize (GMV) value than the old school Amazon that sells goods directly to the consumer.

What this means is that one half of Amazon is like eBay, and the other half is like Wal-Mart. The only difference between eBay and Amazon is that Amazon will sometimes warehouse and deliver third party items through its Fulfilled by Amazon program.

eBay's total GMV is $65 billion (excluding automobiles, which don't generate much in the way of transaction fees or revenue). Amazon's total GMV, including third party sales, is approximately $130 billion; Wal-Mart's GMV is just its revenue, which is $450 billion.

Amazon and eBay are both more expensive than Wal-Mart on a price to GMV basis, but Amazon is now only somewhat more expensive than eBay.

We're not quite comparing apples with apples yet since eBay also owns PayPal, which generates $100 billion of its $150 billion worth of transactions from outside of eBay's marketplace and is growing a lot faster than the rest of eBay is. On the other hand Amazon is growing much faster than eBay. In fact, its third party marketplace is growing at 30% a year, compared to eBay's marketplace growth of only 15%.

Where's the money?
If eBay is nicely profitable, why isn't Amazon? Parts of Amazon are profitable – Amazon's third party marketplace has much higher margins than the rest of Amazon does. But those profits are offset by Amazon's efforts to pursue growth and new business areas.

One way Amazon is driving growth is to offer free shipping, which now costs Amazon over $3 billion dollars a year. Then again, free shipping has proven to be a highly enticing way of getting shoppers to open their wallets.

Amazon is also investing heavily in its Kindle Fire range of tablets in an attempt to grab a bigger share of the $26 billion app market. Costs include the R&D needed to engineer and design the tablets plus the cost of offering new services like Amazon's nifty Mayday video helpline.

Foolish bottom line
If Amazon wanted to show a bigger overall profit then it could cut back on some of those expenses. Alternatively, it could raise prices by a bit. Raising prices by just 3% on its $130 billion of gross merchandise value would generate nearly $4 billion dollars in profit. That would bring its P/E ratio down to a much more reasonable 44. When you further take into account the value of Amazon Web Services, which analysts think is worth around $25 billion , then the rest of Amazon is only valued at a 38 P/E ratio. That's still a shade too rich for me, but is far from an outrageous valuation.