In this article I'm going to present a valuation model that shows that Amazon (AMZN) stock is overvalued but not in a bubble and why recent trends in its operating cash flow growth rate are troubling for the stock.
It's very important for analysts, investors and market watchers to realize that complex companies like Amazon that are going through periods of heavy capex and market share domination can't be analyzed like typical companies are. This does not imply that I'm going to use "new economy" valuation metrics in order to value the company. I'm using a very simple metric to value the stock, projected free cash flow, that is operating cash flow minus an estimate of capex based on historical trends and the company's plans.
Investors that are using GAAP earnings are being extremely mislead about how much this stock is worth. The stock trades at a forward PE multiple of 71 and an infinite PE right now (according to Yahoo), this is leading to a lot of people not understanding the stock and calling it a bubble. I believe the stock is overvalued but it is far from being a bubble (my definition of a bubble is a price level that can't be rationally or mathematically be explained with reasonable assumptions).
I'm looking at this situation differently, I see a company that trades at a 3.5% operating cash flow yield that grew its operating cash flow by 30% compounded since 2003. They ramped up their capex by even more than that because they are betting they can dominate many different markets and achieve economies of scale to the point that they drive competitors out of business, if that succeeds they will be able to increase their margins and deliver more cash to shareholders.
If Amazon could have its operating cash flow compounded growth rate in the double digits the stock would be fairly priced (according to my model), I believe this is why investors are valuing the stock where it is right now, they believe that Bezos' world domination plan will succeed, this is hardly "irrational" or bubble like, its simply an educated guess by investors.
I'm less optimistic about that growth rate and I use conservative estimates, that is the reason my conclusion is that the stock is overvalued. You see, from 2003 to 2012 the compounded growth rate in operating cash flows was 30% but from 2010 to 2012 it was an anemic 6%, indeed in the last earnings report the company missed revenues estimates. The recent trends of slowing down growth in revenues and operating cash flow decreases a lot the future value of this business.
I built an spreadsheet with my valuation model for Amazon that uses the following assumptions:
-Capex as % of operating cash flows starts to gradually go down as the company achieves its investment goals and projects. The % stops at 30% and stabilizes there (the historical figure is 40% since 2003), this represents the maintenance cost of the business, its hard to know precisely what will be the figure so I'm being conservative.
-The growth rate in operating cash flows goes from 10% this year all the way down to 4% over 10 years then 3% into infinity. The 10% this year might be even too high based on recent trends. The actual overall growth rates could end up being higher if the Bezos plan of taking over the world of e-commerce succeeds and he is able to raise prices down the line. This is a prediction that I can't justify making given that recent trends are not encouraging (see chart above) and Amazon has also benefited from the tablet boom, which is coming to an end as competition gets tougher.
-The company's required return is 13%, higher than what is suggested by CAPM simply because I believe the beta in tech stocks understates the risk in those businesses due technological change and the need for innovation specially in a company that is "betting the farm" as Amazon is.
The result of this adjusted DCF analysis is a stock price of $127 a share. With the stock price at $258 I believe the company is overvalued. I used conservative assumptions through the excel file, if I used more liberal numbers in the growth rate section I might get a fair value that is the current stock price. Investors seem to be much more optimistic about how much the company will be able to grow going forward. I encourage the readers to use their own assumptions.
In this article I explained why according to a projected free cash flow analysis Amazon is overvalued but why I don't consider that to be a bubble of any kind. GAAP earnings ratios are misleading investors and making them misinterpret a rational situation where investors simply are optimistic about Jeff Bezos' plan for the future and hence are willing to take more risks than others.
I find the recent trends of slowing operating cash flow growth troubling and this makes me skeptical of taking what the management says at face value. The company has been investing a good percentage of the cash flows for many years and yet it does not seem to be paying off lately.