Back in the halcyon days of the technology bubble, it wasn't unusual to see a company that had anything to do with technology or the Internet carry a ridiculous valuation multiple. Price-to-earnings ratios in the triple digits were far from unusual as investors bid prices up based on potential instead of anything real or tangible. Most of the excess was flushed out of the market as the technology bubble burst and the housing market nearly imploded.
Today, most stocks trade at reasonable valuations. Even technology stocks. But there's one stock whose valuation continues to defy explanation - Amazon (AMZN). The company by virtually any valuation metric looks incredibly overpriced. That alone might temper any upside the stock price might see but the company itself is also facing some potentially stiff headwinds that might ultimately test its position as the alpha dog in the Internet retailer space.
We'll take a look at how those challenges affect what the true valuation of Amazon should look like in a bit but first let's run down some of the issues that Amazon is facing in no particular order.
The stock price's ridiculous valuation
We'll just address the big elephant in the room right off the bat.
Amazon is the largest online retailer in the world. For comparison, we'll line Amazon up against some of the other major retailers out there - Wal-Mart (WMT), Target (TGT), Costco (COST) and eBay (EBAY). eBay doesn't operate as a traditional retailer but, as I'll discuss a little later, it's firing a direct shot across Amazon's bow in order to compete on price and attempt to attract small business retail activity. Therefore, we're including it here.
Here is a table of the major value metrics for each of the five companies.
Amazon is far above the average on price/book, price/sales, price/earnings and PEG ratios. For a pure rapid growth stock, that might be expected but Amazon doesn't quite fit the bill. Analysts are forecasting above average growth for the foreseeable future but actual results haven't followed suit. Earnings have missed street estimates for the last three quarters. Revenue forecasts missed on the last two quarters.
The company is currently sacrificing near-term profitability in order to generate greater revenue growth but when that's the case you have to hit your revenue numbers. Amazon has not.
Part of the justification for such high valuations comes from that expected future growth. Whereas Wal-Mart, Target, Costco and eBay are estimated to deliver 9-14% annual growth over the next five years, Amazon is currently estimating 40% annual growth. Growth like that can warrant a higher than average multiple but considering its recent results and the fact that margins are well below average it's difficult to justify the kind of premium it's currently receiving.
eBay's decision to compete with on Amazon on pricing
Part of the reason that Amazon has grown as big as it has as quickly as it has is its aggressive pricing strategy. Amazon has been able to offer the best prices to retail customers and the cheapest listing fees to business owners looking to sell their products on the website.
Amazon has generated some bad press lately as it looks to quietly raise its fees and now eBay looks like it's going to try to do to Amazon what Amazon has done to everyone else - become the cost leader.
eBay has completely restructured their fee structure to make it simpler and more competitive. eBay will essentially match Amazon's policy on monthly free listings and will charge a simple percentage "final value fee" based on the type of product being sold. And some of those final value fee percentages will be lower than Amazon. Google (GOOG) also appears ready to enter the fray with its Google Shopping Express.
Amazon has been able to call a lot of the shots when it comes to pricing and fee structures but this new competition from eBay won't help the bottom line. Amazon could respond by lowering its own fee structure even further or risk losing existing customers to eBay's platform - both moves which could end up cutting into the bottom line. It's unclear how many Amazon customers would be willing to switch to eBay. Existing customers may be unwilling to switch but it could affect new customer growth.
Congress is close to passing legislation allowing states to collect sales tax on Internet purchases
It's generally not a good thing when a tax law is being passed through Congress with your name attached to it.
In many cases, customers prefer doing their shopping online because they can avoid paying sales tax on their purchases. If Congress has their way, those days could become a thing of the past. Both the House and the Senate are supporting new laws which would allow states to begin collecting sales tax on purchases made over the Internet. It's being dubbed the "Amazon Tax" because Amazon is the largest presence in the online retail world.
It's estimated that it's costing states $24 billion a year in lost tax revenue. For companies like Amazon and eBay, this could ultimately end up increasing the cost of simply doing business (Amazon has actually come out in support of the legislation while eBay has opposed it). In theory, an added sales tax doesn't directly affect a retailer's bottom line but it certainly would make the perceived view that online shopping is tax-free less appealing.
Management is not impervious to bad decisions
Jeff Bezos has gained something of a cult following on Wall Street for his ability to make all the right moves. While Amazon has certainly thrived under his guidance, it shouldn't be assumed that Amazon management can do no wrong.
Case in point - the LivingSocial acquisition. Amazon made a relatively small investment in online deal website LivingSocial just as the business model for daily deal websites was being exposed. In the big picture, it's not a big black mark on Amazon's bottom line but the acquisition was a clear mistake. Bezos attempted to give himself a free pass on the deal by pushing off the loss to a "non-core" operation but a bad business decision is still a bad business decision.
Amazon was recently trading at around $260 a share. Using Amazon's and its competitors' ratios from above, we can begin to assess a truer value of the stock.
Amazon's book value is only $18.04 a share. If you assign the stock a price/book multiple of 3.5 (which is slightly above the average of those of the four competitors listed), you get a stock price of $63.14.
If you assign the stock a price/earnings ratio of 20 (this is comparable to Costco and well above the multiples of the other three but seems fair considering their future growth potential), you're looking at a stock price of $72.94.
Full year earnings estimates for 2014 (according to Yahoo Finance) are $3.60 a share. If you multiply that by the same 20 P/E multiple we used above, we get a stock value of $72.00. And that's for the end of next year.
If we use a PEG ratio of 2.00 (which is a definite premium to those of its peers but, again, perhaps fair considering the future growth), Amazon's stock price calculates to $120.09. Considering its growth potential but also the challenges it's facing, I can't justify a stock price any higher than this.
Truthfully, its fair value seems more consistent with the first three comparisons - a stock price somewhere in the $65-$75 range. The value still gives it a bit of a premium due to its growth but also brings it back in line with its peers. The Internet sales tax issue and the increased competition from eBay are near-term obstacles but there is no denying that Amazon is still the heavy hitter in the online retail space (and likely will be even after these challenges).
However, it's still a far cry from its current $260 price. This stock has priced at a premium for a long time and it could very well stay that way but at this level there appears to be far more downside.