In growing sectors of the economy, we often witness a situation in which some companies tend to become overvalued. A number of factors can contribute to the overpricing of a stock such as market sentiment or false indicators. The internet and technology industry has been subject to miscellaneous waves of growth such as search and social. As consumers have adapted to the most recent trend of mobile, analysts believe that the growth story will continue. Amazon (AMZN) has a very different business strategy which is why analysts have the leeway to expect different from the company. Investors have also supported the idea that Jeff Bezos, Chief Executive Officer of Amazon, is aware of what he is doing. Despite these facts, some serious concerns need to be addressed before a conclusion about the future of Amazon's stock can be drawn.
Industry Standing & Corporate Strategy
It is a fact that Amazon is the market leader in some of the strongest parts of the internet industry. The large capacity of data centers has enabled Amazon to become the market leader in cloud computing. Similarly, the intelligent strategy of combining Kindle Fire with the company's online services has proved successful in generating revenues. The brand name of the company is strong and on its own, it projects a formidable image. The company has been able to tap into the recent trends by introducing products which keep up with the market pace. However, the profitability of the company has been subject to severe limitations.
Amazon's corporate strategy is different from many other players in the industry. The management of the company claims that it aims for long run growth. By doing so, the short-term profitability is completely ignored along with short-term investor considerations. In this situation, investors are left with a promise of growth in the long haul. In the past, investors have bought into these promises as the company's revenue growth has been phenomenal. Since FY08, the company's revenues have projected a CAGR of 33.62%, but despite this growth, this is the right time to ask questions. The company appears to be maturing and the apparent growth seems to be coming from acquisitions because the margins have mostly maxed out. Also, the fact that the company refrains from paying any dividends is likely to help investors reevaluate their positions in the company.
Lessons from Industry Trends
In recent periods, we have witnessed the decline in the share price of Apple (AAPL). The company appeared to be much more 'formidable' than Amazon and investor expectations were strong because Apple was at the heart of every new wave of innovation in the industry. I fully understand the differences between these two companies. My point is that investor expectations tend to appreciate up to irrational levels which is why the prices become distorted. In the case of Amazon, I believe the stock price is ready for a correction as the business's acquisitions and revenue growth is merely an attempt to hide the underlying troubles in the profitability. An adjustment in investor's understanding can be inferred from the stagnation of stock price in recent periods.
Additional Concern: Internet Tax Bill
The US Senate has passed the internet tax bill which is aimed towards almost all the products of Amazon. Specifically, the strong segments of the company such as cloud computing and media downloads will be affected by the tax bill. The extent of the effect is uncertain for now as the stance of states, with respect to practicing their power of exercising the bill, may vary, but most analysts agree that Amazon's earnings will be subject to further concerns with this new bill.
The standing of company's fundamentals has been the main source of concern regarding the company. This is the section where the company has been unable to use its revenue growth to hide the real problem.
Data Source: Morningstar
The above chart shows a comparison between valuation metrics of Amazon and the respective industry. We can clearly see that the price of Amazon's stock remains overvalued across every measure. It is important to note that the P/E ratio of the industry is 73.5 which means that investors' expectations are high. This is because of the growing trends that occur in the internet and technology industry.
The root of the problem is that investors have been aware of the relative pricing of the company with respect to the industry. Their expectations were that the company will continue to grow. These expectations are highly irrational as the phenomenal growth demonstrated in revenues is just not sustainable. The stock price reflects that the investors' awareness regarding the overvaluation is improving. Therefore, the stock price will undergo a process of correction very soon. This is why a sell recommendation is proposed for the near term. An undesirable level of volatility is imminent for Amazon's stock price and investors should keep their distance from the stock until the market completes the price adjustment.