By: Ahmed Ishtiaq
Amazon Inc (AMZN) stock has always been a mystery due to its excessively high multiples, but it has been trading at a P/E ratio of over 100 for a considerable time now. At the moment, investors seem happy to pay a premium for Amazon stock. The company is extremely careful in its efforts to expand and makes investments where the probability of success is high. Nonetheless, it is an incredibly impressive feat to maintain such high price multiples for such a long time. In an effort to solve the mystery, I decided to perform a fair value analysis on Amazon. The model is based on the optimistic expectations placed on the company by Wall Street.
Model Assumptions
Amazon has recorded exceptional revenue growth over the past decade and analysts expect it to maintain current growth levels. The street expects Amazon to grow at a rate of 30 percent over the next ten years. For the first nine months of 2012, the company has already generated about $40 billion in sales. Revenues increased by almost 25 percent from the same period last year. Sales for the fourth quarter of 2011 were around $18 billion, since Amazon sales typically rise during this time of year due to the holiday season. As a result, I have assumed sales of around $20 billion for the fourth quarter of the current year. At the moment, the cost of goods sold is almost 77 percent for the company. I expect Amazon to maintain its current level of sales cost. Moreover, I have assumed a high growth period of four years, where revenues grow at a rate of 30 percent. However, after the hyper growth period, revenues will grow at only five percent. Lastly, most of the operating expenses for Amazon are growing at 20 to 25 percent, with a tax rate of 32 percent.
ProForma Earnings:
2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
Net Product Sales | $42,000 | $52,500 | $68,250 | $88,725 | $115,343 | $149,945 | $157,443 |
Product sales as a percentage of total sales | 87.36% | 87.87% | 86.65% | 85.77% | 85.31% | 85.31% | 85.31% |
Net Services Sales | $6,077 | $7,250 | $10,513 | $14,718 | $19,869 | $25,829 | $27,121 |
Services sales as a percentage of total sales | 12.64% | 12.13% | 13.35% | 14.23% | 14.69% | 14.69% | 14.69% |
Total Net Sales | $48,077 | $59,750 | $78,763 | $103,443 | $135,211 | $175,774 | $184,563 |
Operating Expenses: | |||||||
Cost of Sales | $37,288 | $46,008 | $60,647 | $79,651 | $104,113 | $135,346 | $142,114 |
CGS % | 77.00% | 77.00% | 77.00% | 77.00% | 77.00% | 77.00% | 77.00% |
Fulfillment | $4,576 | $5,800 | $7,250 | $9,063 | $11,328 | $14,160 | $14,868 |
Marketing | $1,630 | $2,140 | $2,675 | $3,344 | $4,180 | $5,225 | $5,486 |
Technology and content | $2,909 | $4,126 | $5,158 | $6,447 | $8,059 | $10,073 | $10,577 |
General and Administrative | $658 | $810 | $972 | $1,166 | $1,400 | $1,680 | $1,764 |
Other operating expense (income), net | $154 | $162 | $170 | $178 | $187 | $197 | $206 |
Total Operating Expenses | $47,215 | $59,045 | $76,871 | $99,849 | $129,266 | $166,681 | $175,015 |
Operating Income | $862 | $705 | $1,891 | $3,594 | $5,945 | $9,094 | $9,549 |
Interest Income | $61 | $51 | $56 | $58 | $61 | $62 | $64 |
Interest Expense | -$65 | -$72 | -$74 | -$75 | -$77 | -$79 | -$82 |
Total non operating income (expense) | -$4 | -$21 | -$18 | -$17 | -$16 | -$17 | -$18 |
Income before Taxes | $858 | $684 | $1,873 | $3,577 | $5,929 | $9,077 | $9,531 |
Provision for taxes | $291 | $219 | $599 | $1,145 | $1,897 | $2,905 | $3,050 |
Tax Rate | 32.00% | 32.00% | 32.00% | 32.00% | 32.00% | 32.00% | 32.00% |
Net Income | $567 | $465 | $1,274 | $2,432 | $4,032 | $6,172 | $6,481 |
EPS | $1.25 | $1.03 | $2.76 | $5.09 | $7.87 | $11.87 | $12.34 |
According to the ProForma earnings model, Amazon should be able to generate $6.4 billion in profits in 2017 and an EPS of $12.34.
Valuation
For valuation purposes, I have assumed a discount rate of ten percent. Amazon has a strong history of revenue growth, healthy cash reserves and an immensely strong business model. Taking into account the strong position of the company, I believe a discount rate of ten percent is justified.
Valuation | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
Earnings | $1.03 | $2.76 | $5.09 | $7.87 | $11.87 | $12.34 |
Discount rate | 10.00% | 10.00% | 10.00% | 10.00% | 10.00% | 10.00% |
Present Value Factors | 0.95 | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 |
Discounted Earnings | $0.98 | $2.51 | $4.21 | $5.92 | $8.11 | $7.66 |
Terminal year Value @5% constant growth | $129.57 | |||||
Discounted Terminal Value | $80.45 | |||||
True Value | $109.83 |
There are two conventional methods to calculate the terminal year value: the multiple of terminal year earnings and a constant growth model. I have used the latter, and assumed a five percent constant growth rate after the high growth period of five years. In addition, the terminal year earnings of $12.34 have been discounted using the single stage growth model.
For the single stage model, earnings are first adjusted for constant growth and then reduced by the discount rate. The single stage growth model also adjusts the discount rate for growth by deducting the terminal growth rate from the discount rate. Once the terminal year value is calculated, it is then discounted to reach its present value. On the other hand, earnings before the terminal year are simply discounted to reach present values. Finally, the discounted earnings are added to the discounted terminal value to reach the true value/fair value of the stock. Therefore, according to this valuation model, Amazon should trade at $109.83. The stock is currently trading at a significant premium to its fair value.
Even with the lofty expectations and a low discount rate, the stock is massively overvalued and expensive. However, if Amazon is able to grow at 35 percent for the next four years and reduce COGS to 70 percent, results can change dramatically. I tweaked my assumptions and offered Amazon a more favorable growth rate and better sales costs. As a result of these changes, the model generated an EPS of $39.87 for 2017 and fair value of $357.14. However, it should be kept in mind that these assumptions are extremely optimistic and will be hard to achieve.
Comparison with Peers
Amazon's chief competitors include Best Buy Co, Inc. (BBY), Barnes & Noble, Inc. (BKS) and Apple Inc. (AAPL). Amazon competes with Apple mainly in the tablet market. Amazon recently launched its new line of larger and faster Kindle e-readers, which appear to be intended as alternatives to the popular Apple iPad. Apple is also expected to launch a smaller and cheaper iPad by the end of 2012 that is intended to compete more closely with Kindle.
AMZN | AAPL | BKS | BBY | |
P/E | 227.29 | 14.80 | N/A | N/A |
P/B | 14.60 | 5.30 | 1.30 | 1.70 |
P/S | 2.10 | 4.00 | 0.10 | 0.10 |
EPS Growth | -2.80% | 59.80% | N/A | N/A |
Operating Margin | 1.20% | 35.60% | -0.50% | 2.10% |
Net Margin | 0.70% | 27.00% | -0.70% | -2.40% |
ROE TTM | 4.90% | 44.30% | -7.20% | -23.80% |
Debt to Equity | 0.00 | 0.00 | 0.40 | 0.30 |
Source: Morningstar.com
For a long time now, Amazon has been consistently trading at a premium in comparison with its closest peers in the market. Even so, the company has always been able to provide investors with healthy returns. Amazon has an impressive history of revenue growth and exceptional growth potential.
Summary
According to my valuation model, Amazon stock is considerably overvalued at the moment. Nevertheless, thus far Amazon has been able to defy logic and trade at these extremely high multiples. However, the model discussed here suggests that, though exceptional, the company's growth does not justify its price. In fact, in order to justify current price levels, Amazon will have to grow at a rate of over 30 percent and bring down its costs substantially. This would be a very difficult feat for any company to accomplish.
In my opinion, Amazon will not be able to grow at such a high rate and bring down its costs simultaneously. Yet, it is almost impossible for any company to grow at such high rates indefinitely. Eventually, the growth rate will come down closer to the growth rate of the economy. In the current economic environment, I do not believe the company can maintain its expected growth rate of above 30 percent. On the other hand, if revenue growth does carry on in the short term, the stock price will follow and will remain high. Most likely, in the long run, the stock price will converge with fair value estimates leaving Amazon to trade at lower multiples.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
