By any measure, Seattle-based online mega-retailer Amazon has had a terrific run. In the last decade, revenues have increased by about 28% per year, cash flow per share has increased by roughly 36% per annum and the share price has gone from $51 to $1,591 representing a 41% yearly compound increase. Moreover, the company is poised to continue to dominate and shape the online retail industry.
There have really only been a few knocks against the security. For income investors, the lack of a dividend has been a sticking point. Furthermore, considering that the firm is still in growth mode, it appears unlikely that a dividend is in the near future.
Theoretically you could sell covered calls against a stake in Amazon to generate supplemental cash flow without outright selling shares, but the capital requirements of a 100-share round lot would be quite high. For better or for worse, this is one reason some investors have avoided the security.
A second sticking point has been the security’s valuation. Until recently, Amazon’s earnings-per-share equated to just a few dollars resulting in a sky-high price-earnings ratio. More recently, the company has started to show solid improvement on the bottom line. In the past twelve months Amazon has reported $16.24 in earnings-per-share. Against the current share price of $1,591, that equates to a trailing valuation of 98 times earnings.
We’re still in the “sky high” arena, but the expectation is for the bottom line to improve dramatically in the years to come.
Now here’s where the investing world gets interesting. Everyone knows that Amazon has had a terrific past, there’s no denying that. Further, most would agree that the future continues to look bright for the company. However, neither of those two points are the pertinent question today’s prospective investor needs to be asking themselves.
Future growth is not the question. The real question is what amount of future growth is required. That is: “what does Amazon need to do from this point to justify its current valuation?”
Often an investment process might look like this:
- Survey a company’s current earnings power.
- Make a judgment about the quality of a business.
- Come up with an expectation for future growth.
- Project out into the future.
- Compare those assumptions to the current price.
- Compare this result to your applicable alternatives.
The difficult portion is coming up with a growth rate. And for a company like Amazon, it’s really difficult. You have such a strong past, but now you’re dealing with one of the largest firms on the planet. The base from which growth is required gets more and more difficult as the company takes more and more of the industry.
So let’s flip this process upside down. Instead of coming up a growth rate, we’ll let a growth rate come to us. We will achieve this by figuring out the answer we want and then working backwards to see what this would require.
Let’s work through an illustration to get a better idea of what I mean.
Shares of Amazon currently trade at $1,591 and do not pay a dividend. Obviously we know that the past share price appreciate has been heroic. However, today’s prospective investor would not anticipate that same result. For illustration, suppose that a 12% annual return would be adequate over the longer-term (we’ll say 10 years here).
This means that the share price would need to climb from $1,591 to around $4,940 or thereabouts after a decade. Now the question is what is needed to get to this point.
By that time Amazon ought to be bringing earnings to the bottom line on a “normalized” basis. In the growth stage profits are reinvested, making it look like the company has potential but not much profit. After another 10 years, the growth stage will in all likelihood be slowing and earnings-per-share should paint a clearer picture of what Amazon can produce. Indeed, we’re already seeing this develop in the last year or so.
We don’t have a historical price-earnings ratio to go on for Amazon, but we do have some precedent. Firms like Apple (AAPL), Alphabet (GOOG) (GOOGL), Cisco (CSCO) and Microsoft (MSFT) were once high fliers with similar growth trajectories, but have since come down to sensible valuation multiples. No matter how great a growth story, eventually you get to a normalized earnings multiple.
For our purposes let’s suppose that shares of Amazon eventually trade at 20 times earnings. Hard to imagine today, but a similar statement could have been made for other exceptionally fast growers.
At that rate, and the roughtly $4,940 required price mentioned above, this would mean that Amazon would need to earn about $247 per share in the next 10 years. Compared to the trailing mark of $16.24, this means that Amazon would need to growth earnings per share by roughly 31.3% per year.
That’s a lofty growth rate, especially considering that it is pretty close to what was achieved in the past decade when the firm was much, much smaller. (By the way, given a constant share count, this would also imply the business trading with a market capitalization of $2.4 trillion or so.)
Of course this is only one possibility out of many. Here’s a look at a few more:
A future price-earnings ratio of 15 = requires 35.1% earnings per share growth for the next 10 years to generate 12% annual gains
- P/E 20 = requires 31.3% EPS growth
- P/E 25 = requires 28.4% EPS growth
- P/E 30 = requires 26.1% EPS growth
- P/E 35 = requires 24.1% EPS growth
- P/E 40 = requires 22.5% EPS growth
Naturally your personal arithmetic may not require a 12% annual return, but the idea is to see what is required. In order for Amazon to justify its investment thesis, you likely need to see 20% to 30% growth for the next decade.
Incidentally, analysts are currently suggesting that this growth rate (and indeed much more) is possible at least for the next few years. The question you need to ask yourself is about the sustainability of this tremendous growth in the years to follow. The future will always be foggy in the investing world, the idea is to see what is required and determine whether or not your personal views fulfill those expectations.
Disclosure: I am not long any of the stocks mentioned in this article.
