Conventional wisdom from value investing says that Amazon (AMZN) is extremely overpriced. In Ben Graham’s “The Intelligent Investor”, he says that it is generally not wise to buy a stock over 1.5 times its book value, although it would be okay to slightly overpay if the P/E was below 15. Now how about a price-to-book (P/B) ratio of 14.3 and a P/E of 509? It seems absurd that a value investor would consider buying this stock given those extremely high valuations. But when you take a step back to think about it, how much would someone be willing to pay for a company that is single handedly destroying everyone in the retail industry? I am pretty sure it would be more than $15.9 billion, 1.5 times Amazon’s book value.
So what is the value of a company that continuously sacrifices income for rapid revenue growth? Over the past ten years, Wall Street has determined that value to be 2.1 times sales. The chart showing its 10-year median price-to-sales (P/S) ratio shows that the price of the stock consistently reverts back to 2.1 times sales.
Revenue has been increasing at a rate of 20 percent so far this year. If the trend continues, revenue per share will be $192.13 by the end of the year, valuing the stock at $403.38 by year end. The stock closed at $320.00 on Tuesday, July 29, 2014.
As I thought about using price-to-sales as a metric, I wondered why the stock deserves such a high P/S ratio compared to its competition. Wal-Mart (WMT) has a P/S ratio of 0.50 and Target (TGT) has a ratio of 0.53. The difference is that Amazon has a long-term growth rate of 30 percent while Wal-Mart and Target have growth rates of 6.5 to 8.5 percent over the past five years. Amazon is growing at a rate 4 times as fast, making a P/S ratio of 2.1 a near perfect value figuring its growth rate compared to the P/S ratios of its competition.
Bill Nygren of the Oakmark Fund had some interesting comments about Amazon that gave me a better understanding of the stock’s valuation:
Third-party sales (sales on amazon.com where the seller is not Amazon) have grown more rapidly than Amazon’s direct business. And on those transactions, accounting rules credit only Amazon's commission as revenue. So if you buy a $100 item on amazon.com from a third party, Amazon is only allowed to show about $13 of revenue, nearly all of which is gross profit. For third-party sales, Amazon is effectively functioning as the mall owner, collecting a percentage of sales as rent. Amazon earns less gross profit on that sale than an average retailer would, but it is also a much lower risk endeavor. For that reason, we think a dollar of third-party sales should be worth about the same as a dollar that Amazon sells directly.
It gets interesting when we adjust our cap-to-sales ratio comparison to include estimated gross third-party sales. Instead of selling at twice the ratio to sales of the average bricks–and-mortar retailer, Amazon is selling at only 80%. So, relative to gross sales, Amazon's stock would have to increase 25% to be priced consistent with the very companies whose survival Amazon is threatening. On that metric, Amazon has never been cheaper.
His comments also tied in to what Bill Miller of Legg Mason said about the company during a CFA dinner in Dallas. Bill Miller was very positive about the stock and mentioned that the internet is providing virtual real estate. I dismissed the idea because virtual real estate is limitless unlike real physical property. Bill Nygren (Trades, Portfolio) gave the perfect explanation to help me understand the concept. With its massive customer base and competitive advantage, Amazon has the most valuable virtual real estate for vendors to sell products while it collects the rent.
Although the company is already a market leader, it continues to spend in order further innovate and strengthen its market leadership. In Founder and CEO Jeff Bezos’ latest letter to shareholders, he highlighted some of the initiatives from Prime to Amazon Smile, to Mayday. He then went on to name 21 of the initiatives with brief explanations. He also said that there are many other programs that are just as promising, consequential, and interesting as those highlighted.
In Bezo’s annual letters to shareholders, he also includes the initial 1997 letter as evidence that the company is staying true to its original plan. There are plenty of important bullet points in the initial letter, but three of them that stand out in relation to valuing the company:
- We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
- We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.
- When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
To sum it up, Amazon is not just throwing money away with its initiatives. The company is analyzing each initiative to determine whether or not it will lead to an increase in the present value of cash flows. At this point, we have to take Bezo’s word for it since we cannot see the analysis of the projects. He does have an excellent track record that gives him plenty of credit.
Getting back to the valuation aspect, the enormous spending on projects makes it difficult to value the company. To take a shot at it, what would Amazon’s earnings be if the company just decided that it has spent enough on these huge projects and will just maintain its current business? The company is already dominant and can maintain its market leadership. If the company did decide to only focus on its current business, its net margin will definitely be higher than Netflix’s (NFLX) at 2.57 percent, but it will likely be lower than Google’s (GOOG) and Apple’s (AAPL) net margins of around 20 percent. eBay’s (EBAY) net margin was 17.8 percent for 2013. Amazon’s fulfillment centers and Prime Instant Video will draw the net margins down toward lower half of the range. To keep it simple, we can use the net margin of 8.5 percent Amazon was able to obtain in 2004. It is a number that fits well within the range was attainable by the company at one point.
If Amazon decided to reduce its massive spending on innovation and just decided to maintain its market leadership with smaller projects, the company would be earning $16.33 per share for the full year of 2014. With earnings of $16.33 per share, Amazon would only have to grow at a rate of 14.34 percent to maintain its value according to the GuruFocus DCF Calculator with a default discount rate of 12 percent. The company has been growing its revenue at a high annual rate of 30 percent over the past 5 and 10 years. For the past year, revenue increased 20 percent. Using a 20 percent growth rate in the DCF calculator leads to a fair value of $464.89. Although, if the company did stop being the innovator it has been, growth would likely start to slow down from that level in a few years.
Even though there are many factors that would lead conventional value investing wisdom to say Amazon is extremely overpriced, when considering its market leadership and the moat it has created, the stock has plenty of value. Most of the retail industry is trying to figure out how to compete with Amazon, but it just keeps getting stronger. Of course, based on current earnings, the stock is largely overvalued, but the earnings are depressed based on investing in projects that add to the present value of cash flows. It would be great to see what the present value of its cash flows is, but that is all up to speculation. For now we have to trust that Jeff Bezos stays true to his word and does the proper analysis on his initiatives.