Is Amazon Expensive? Not To Me

Jan.31.13 | About: Amazon.com, Inc. (AMZN)

Shares of Amazon (NASDAQ:AMZN) have returned 45.4% over the past 12 months. At $272.76 per share, the stock is trading close to its 52-week high of $284.72 attained just recently as result of the company's solid Q4 earnings release. At this price, Amazon is valued at 141.0x forward EPS, which is considered to be a lofty valuation level by many investors. However, I am of the view that Amazon is now reasonably priced. In this article I will elaborate on my valuation analysis, which supports my view and may also help you in formulating an appropriate investment decision.

Relative Valuation

First of all, while many investors' investment decisions are still largely driven by the stock's P/E valuation, I believe trading multiples based on revenue, EBITDA, and free cash flow (i.e., EV/Sales, EV/EBITDA, EV/FCF, and P/Sales) are more relevant valuation indicators for Amazon. That's the case provided that the company's strategic focus remains on driving top-line growth and generating stable free cash flow by continuously reinvesting in existing business and potential opportunities to expand market share. Now, let's take a look at the comparable multiple analysis.

Sell-side analysts on average predict Amazon's revenue and EBITDA to grow at significant CAGRs of 26.9% and 38.0%, respectively, over the current and next years (see comparable analysis chart below). Those consensus growth estimates are considerably above the averages of 12.7% and 11.8%, respectively, for a group consisting of Amazon's primary peers. Similarly, the firm's EBITDA margin is forecast to expand by 1.0% over the same horizon, compared to the peer average of just 0.2%.

On the profit side, however, Amazon's profitability underperforms that of the peers across all the listed measures as the top-line growth and the cash flow stabilization are currently the company's priorities. In terms of leverage, Amazon carries a relatively higher level of debt as reflected by the firm's above-average debt to capitalization and debt to EBITDA ratios. However, the leverage still appears to be healthy on an absolute basis.

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As such, Amazon's superior growth potential would continue to be the primary support to the stock valuation. However, given the relatively weak profitability margins, I believe the stock's valuation would still be somewhat impacted (i.e., limited valuation premium). The current valuations at 1.9x forward EV/Sales, 23.1x forward EV/EBITDA, 30.7x trailing EV/FCF, and 2.0x P/Sales together represent an average premium of just 10.0% above the peer-average trading multiples (see chart above). That suggests that Amazon's current price level appears to be reasonable.

Let's take a historical standpoint. Amazon's trailing EV/Sales and EV/EBITDA multiples are now trading at 1.9x and 43.4x, respectively, very much in line with their five-year historical averages at 1.9x and 40.0x, respectively (see charts below). I believe the in-line valuation is substantiated by the trajectory of the company's financial performance provided that 1) Amazon's expected revenue growth rates for the next eight quarters are not far off from the average growth rate over the past five years, and 2) the market expects a considerable improvement in Amazon's EBITDA margin over the next eight quarters (see charts below).

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DCF Valuation

To support my view, I also performed a DCF valuation that incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2017 (see DCF chart below). The purpose for this analysis is not aimed to predict a fair stock value, but to gauge the various assumptions embedded in the current share price and test the valuation's margin of safety.

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The revenue growth from fiscal 2018 to the terminal year is assumed to decline to 3.5% for conservatism, and the EBITDA margin over the same period is estimated to decline to 8.0%, which is consistent with the market's average estimated margin from fiscal 2013 to fiscal 2017. Other free cash flow related items including tax expense, depreciation and amortization, capital expenditure, and non-cash working capital investment are projected based on their historical figures relative to the total revenue.

It should be noted that the depreciation and amortization as well as the capital expenditure are assumed to be equal in the terminal year based on a rationale that the depreciation expense will eventually catch up with the company's capital spending. Amazon has a track record of experiencing annual release of non-cash working capital. To be conservative, I modeled the non-cash working capital investment/revenue ratio to gradually change from -4.1% to -1.5% (less cash flow release over time) over the forecast period.

A company-specific risk premium of 3.0% is applied in the cost of equity calculation to account for the financial forecast risk. As such, based on a reasonable WACC of 11.2%, a terminal growth rate of 3.5%, and a relatively low implied EV/EBITDA multiple of 8.7x in the terminal year (currently at 23.1x as mentioned earlier), the model yields a stock value of $271.71, which is fairly close to the current share price at $272.76. It is noted that the model capitalizes an implied free cash flow margin of only 5.4% in the terminal year, which is notably below Amazon's historical free cash flow margin of 6.4% between fiscal 2003 and fiscal 2012. Since the assumptions employed in the model are mostly conservative or reasonable, this analysis suggests that Amazon's share price is not expensive at all.

According to Thomson One, Sell-side analysts continue to favor this growth stock. Of the total 39 stock ratings, there are 11 strong buys, 19 buys, eight holds, and only one underperform. In a recent research note, Deutsche Bank's research analyst Ross Sandler elaborated on his bullish, view which I tend to agree on (sourced from Thomson One, Equity Research):

AMZN is our favored name in large cap e-commerce, as it is one of the few companies that could increase its revenue 10x over the next several years ... AMZN trajectory heading into 2013 is as solid as any company in the Internet space. Growth remains at a healthy 40% clip, measured by gross profit (excluding exchange rate impact), and margins could start to improve for the first time in several years. The key factor driving the margin expansion is AMZN's fulfillment investments starting to turn the corner. Most of the bear case around AMZN has been diminished or better understood, including cannibalization of its core physical media franchise by digital, unit economics deteriorating as Prime membership increases, decelerating revenue growth from 1-P to 3-P mix shift, and of course, the steady decline in margins.

Bottom line: Amazon's share price appears to be reasonable based on the above analysis. Given the robust growth prospects, I believe a buy rating for Amazon is completely warranted.

The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts is sourced from Capital IQ unless otherwise noted.

Disclosure: I am long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.