Amazon’s Valuation Problem

People always ask, “when will Amazon make a profit?”

Bloomberg: Bezos Alarms Amazon Investors With Spending Pace as Loss Widens
(via Daring Fireball)

Jeff Bezos is testing the patience of investors after Inc. missed analysts’ estimates for a second straight quarter, sending the shares tumbling 11 percent.

The world’s largest online retailer yesterday reported a second-quarter loss of $126 million, more than double what was predicted, even as sales climbed 23 percent to $19.3 billion. Expenses jumped 24 percent to $19.4 billion. […]

The loss in the latest period was the biggest since the third quarter of 2012, when Amazon posted a $274 million loss. Looking ahead, Amazon projected sales of $19.7 billion to $21.5 billion for the current quarter. Operating losses are projected to be $810 million to $410 million, Amazon said.

Amazon gets treated by investors like a brand new start up. A common thought has been that Amazon is a company that is just waiting to flip the switch and can at anytime start to make as much profit as they want. The thought follows that the only reason Amazon is not making a profit now is because they aggressively pour so much money back into the company for new/existing projects.1

As of today Amazon closed at $324.01, down 9.65% today on the bad news listed above. What might justify Amazon’s stock price given the lack of profits?2 Let’s use a simple model to understand what the market is thinking.

The Model
Price = NI / (r -g)

Price = the stock price per share today
NI = the firm’s net income per share one year from now
r = the discount rate
g = the growth rate

Many of you will recognize this as a modified version of the dividend discount model. Instead of dividends I will be using the net income amount. 3 Now all we need to do is estimate the inputs to our model, the net income, discount rate, and growth rate. Stock price is positively related to changes in net income and the growth rate but negatively related to the discount rate. The higher you think the firm’s cash flows or growth rate will be, the more you are willing to pay for it today. If you think the firm will be riskier, as captured by the discount rate, then the price you would be willing to pay decreases.

Scenario #1
Assuming Amazon could achieve Walmart’s profit margin, Amazon would earn just $5.63 per share, their discount rate would be 12%, and the growth rate would be 3%. Using these values Amazon’s stock price should be just $62.56.

Scenario #2
Assuming Amazon could achieve Lululemon’s profit margin, Amazon would earn $26.27 per share, their discount rate would be 12%, and the growth rate would be 3%. Using these values Amazon’s stock price should be just $291.89.

Scenario #3
Assuming Amazon could achieve Apple’s profit margin, Amazon would earn $36.52 per share, their discount rate would be 12%, and the growth rate would be 3%. Using these values Amazon’s stock price should be just $405.78.

Scenario #4
Assuming Amazon’s actual outcome represents some weighted average of the prior scenarios, Amazon would earn between $17.05 and $20.46 per share, their discount rate would be 12%, and the growth rate would be 3%. Using these values Amazon’s stock price should be between $189.44 and $227.33.

Three of the four outcomes indicate that Amazon is overpriced and in most cases by quite a large margin. Delaying the first year of profits only exacerbates the problem. Suppose the best case, scenario #3, is the true outcome, but instead of happening this year we delay it by just one more year; the current price of Amazon’s stock would fall from $405.78 to $362.12. 4

The market is right to be nervous about when/if the profit machine switch can be flipped at Amazon.

How did I arrive at these scenarios?

Estimating Net Income5
Amazon has historically made very little net income. Let’s assume Amazon can flip the switch from no profits to some amount of profits. I have three comparable companies off which to generate Amazon’s hypothetical post switch flip net income. These three com parables will establish upper and lower bounds on Amazon’s potential profitability.

Walmart – Amazon is a large retailer selling many low margin products that compete with Walmart. Amazon is on the record as saying they would like to be the largest retailer in the world. If they could take that crown, isn’t it reasonable to expect their margins to be similar to the current largest retailer? Walmart has $146.74 of revenue per share with earnings per share of just $4.84. Walmart’s profit margin is just 3.3%. If Amazon had a profit margin of 3.3% their net income would have been $5.63 per share.

Lululemon – Perhaps using Walmart is not appropriate since Amazon does sell a larger variety of high priced items than Walmart ever will. Perhaps using a high margin retail like Lululemon is more appropriate. Lululemon’s profit margin is much higher at 15.41%. If Amazon had a profit margin this high their net income would have been $26.27 per share.

Apple – Amazon is following Apple’s lead in many respects. Amazon has steadily increased the amount of virtual goods they sell. They have an ebook store, music downloads, video streaming among other services. Amazon develops their own flavor of Android and now sells a phone and a tablet device. This certainly starts to feel a little more like Apple.6 Apple, who is the poster child for high margins and solid profits has a profit margin of 21.42%. Given this high profit margin, Amazon’s net income per share would have been $36.52.

I personally tend to think that Amazon’s profit margin, should the flip the switch would be closer to 10%-12%. This opinion is based on the average profit margin that I think would be generated by Amazon’s different units. This would put their net income between $17.05 and $20.46 per share.

Estimating the discount rate
The discount rate is the rate that converts future cash flows to present cash flows. The rate is a function of the real rate of return, an inflation premium, and a risk premium. We can estimate Amazon’s discount rate using a naive approach, setting the rate at or near the historical market discount rate of 12%. Using the Capital Asset Pricing Model (CAPM) to derive the discount rate. The with Amazon’s beta of 0.77, the CAPM indicates their discount rate is about 10%.

Estimating the growth rate
This growth rate represents the long run growth rate of the company’s earnings. The historical growth rate of the overall economy is approximately 3%; this makes for a very reasonable assumption as it is unlikely that a firm can forever grow faster than the economy as a whole.

  1. Occasionally in casual conversations I ask people how old they think Amazon is… it’s ok if you don’t know. Amazon was founded in 1994 and became a public company in 1997. We are talking about a 20 year old firm here that has yet to make any significant profit.

  2. Remember that the price alone of a stock means nothing. Share price must be given context. This is why price to earnings ratios are so frequently cited. They give context to an otherwise abstract number.

  3. I choose net income because not all firms pay dividends and, with a couple of assumptions, paying out dividends is irrelevant to the value of a firm. Some might argue that I should use free cash flow; given the simplicity of the model the choice between net income and free cash flow is not highly impactful.

  4. This calculation is performed by discounting the price by one year which is done by dividing the price by 1 plus the discount rate.

  5. Revenue, earnings, and profit margin amounts in this section represent totals from the trailing twelve months. Earnings are diluted earnings per share.

  6. although Amazon sell these devices and offers some of these services as a way to entice users to spend more on products through; Amazon’s devices are sold at near to break-even prices counting on this fact

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