Amazon.com (NASDAQ:AMZN) is an online retailer that has been showing an impressive revenue growth for several years now, thanks to the growth of online shopping. This growth is expected to continue in the future as Forrester projects that online retail revenues will reach $370 billion by 2017. Consequently, investors place high-value on the stock of Amazon, the leader in this growing market, and hence it is trading at a sky-rocketing P/E (TTM) of around 519. Although Amazon is a high-growth business, this level of valuation is not justified due to the low-margin business model of Amazon.

At the end of the day the margin does matter
Amazon is fundamentally a low-margin business. To get a clear perspective, consider that the company takes ownership of the inventory and stores it in the warehouses, pretty much like Wal-Mart Stores (NYSE:WMT). The only difference is that Wal-Mart uses the brick and mortar stores for the sale of its inventory while Amazon does it online. This can result in cost-savings for Amazon. However, there are delivery costs and the costs of owning and running the servers. The point is that the total costs are almost the same for Amazon and Wal-Mart. Wal-Mart couldn't increase its margin beyond 4% with its $477 billion revenue in 2013. Therefore it will also be quite difficult for Amazon to do so.


Source: Yahoo finance

It can be argued that the above-mentioned P/E is justified because of the high growth prospects of Amazon because higher R&D expenses will decrease eventually as growth settles. But this is not enough. Competition from Wal-Mart and Alibaba.com will put pressure on the growth of Amazon. Therefore, the forward P/E of 108.27 can't be justified by the growth prospects that are threatened by the competition. Furthermore, the P/S of Amazon is around 1.99 over the past twelve months while the P/S of Wal-Mart is around 0.51, indicating that Amazon is currently expensive irrespective of the costs. All in all, it would be difficult for Amazon to trade at this P/E amid its low-margin business and the competition ahead.

The competition
High-growth industries entail competition. Therefore, Amazon is facing competition from Wal-Mart, which is now the fourth largest e-commerce retailer. Wal-Mart is putting price-pressure on Amazon. To put this into perspective, see the chart that follows:


Source: Kantar Retail 

 

The competitive pricing from Wal-Mart will force Amazon to reduce its prices, thereby resulting in pressured-margins.

Yet another alarming development is the expansion of Alibaba.com, the largest e-commerce platform of China, in the U.S. market. Alibaba is launching an e-commerce website, 11 main, in the U.S. Unlike Amazon, Alibaba serves as a platform for buyers and sellers, and the company earns a fee or a commission for its services. The point is that Alibaba can collaborate with conventional retailers of the U.S. by providing them with a selling platform for a specified fee. Amazon can't do that because it takes ownership of the inventory, and hence it competes directly with the conventional retailers. Therefore, Alibaba's presence in U.S. can increase the online footprint of conventional retailers, thereby intensifying the competition for Amazon.

The diversification argument
Bulls frequently argue on the basis of Amazon's diversification into the Web Services. Amazon web services, or AWS, is the leader of the public cloud, there is no question about that. But the competition is ramping-up on this front. Gartner says , "AWS is beginning to face significant competition – from Microsoft in the traditional business market, and from Google in the cloud-native market. So far, it has responded aggressively to price drops by competitors on commodity resources.

Bottom line
Online retailing is set to grow. Amazon's business will also grow despite the competition. The problem does not lie with the business itself rather it lays within the valuation of the company's stock. The company will continue to operate successfully at a lower margin. However, at the current price, the P/E ratio of Amazon is not justified amid margin pressures and the competition ahead. Once the market realizes that, a correction period could follow.

 

Sid A. has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Apple. The Motley Fool owns shares of Amazon.com and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.