Valuing Amazon Like the Next Wal-Mart

For a while, during the dark days of the credit crunch, Amazon’s (AMZN) P/E came back down to earth, but once again it is flying high, looking like a dot com deja vu bubble. Is that bad? I don’t know. It depends. If Amazon’s cash flows are disjointed from its NI, then a P/E of 70 could be perfectly reasonable (or not), but you won’t know till some analysis is done.

If you ask 5 people the definition for Free Cash Flow (FCF) you should generally get the same answer. If you ask them to write the equation, you will likely get 5 different equations. FCF needs to be tailored for each company to make sure you are indeed calculating the CF desired for your intended use (valuation, operational liquidity, etc). For AMZN I used the below equation with results for the last 3 years posted below:

FCF = NI + Changes in deferred income

+ Depreciation – Capital expenditures

+ Stock-based compensation + Excess tax benefit from stock-based compensation

+ Changes in Working Capital

Note: Depreciation and Capital Expenditures have essentially canceled out over the last 3 years and will be ignored. This eliminates the need to project these values into the future, which vastly simplifies the valuation process. Stock-based compensation + Excess tax benefit from stock-based compensation will be referred to as “stock-based compensation.”

To value Amazon, I first calculated discounted cash flows (DCF) in a strait forward, text book, manor with declining growth rates over 8 years followed by a terminal growth rate of 5%, but I then realized two major problems with this model:

1. What should the declining growth rates look like? How many years should I go out before hitting terminal growth?
2. NI and deferred revenue only make up 52% of Amazon’s cash flow, and the other two major components do not all change at the same rate, so a ‘one size fits all’ CF growth rate model will not work. I would hope that NI growth from sales will outpace the growth in stock-based compensation. Also, CF from changes in working capital will not grow at the same rate as sales growth.

To solve the first problem, I looked to Wal-Mart’s (WMT) historical revenue growth rates to see if I could find a time in Wal-Mart’s life that looks similar to Amazon’s last few years (see graph below). I found that Amazon’s sales growth rates from 2002 to 2008 (green line) very closely follow Wal-Mart’s sales growth rates from 1988 to 1994 (blue line). This is more of a convenient coincidence than anything else. Also note that today, Wal-Mart’s sales growth rate has still not reached a textbook DCF terminal rate of 3-5%.

Amazon's growth rate is running slightly higher than Wal-Mart’s for the referenced period, so I added 1% to Wal-Mart’s trailing 5-year average (1995 to 2009) to arrive at the sales growth rates to use in a DCF model for Amazon from 2010 to 2023. With 2009 revenues approaching $24B, and using Wal-Mart’s growth rates (+1%), 2023 revenues come in at $185B, which seems reasonable given the time frame of 14 years. .

To solve the second problem I used Adjusted Present Values (APV), split up the cash flows, and projected them out separately as follows:

• NI + Deferred Revenues: CF from NI was projected at 3.4% of sales plus the CF from deferred income at 1.5% of sales gives at a profit margin of about 5%. From there I created two scenarios: one where profit margin stays at 5% and one where profit margin grows from 5% to 7% over several years to model the possibility that Amazon will, with scale and e-books, make some headway on their margins.
• Stock-based compensation makes up 28% of FCF and is about 2.5% of sales. There is no precise way to project this number. It is determined by Amazon’s compensation policy. I looked to Wal-Mart for guidance, and found they don’t use stock-based compensation. Intel’s (INTC) stock-based compensation is about 10% of operating cash flow. I decided to gradually move Amazon towards what Intel was doing, so I modeled stock-based compensation peaking at $1.1B in 2016, and then gradually coming down to 10% of FCF by 2020.
• Changes in Working Capital: I maintained Amazon’s inventory, accounts receivable (AR) and accounts payable (AP), as a percentage of sales (CGS for AP), at their Q3 2009 TTM averages of 6.4%, 3.2% and 18% respectively. For a company that will be growing for the foreseeable future, I view changes in working capital as a perpetually growing, continuously rolled over, free loan. Yes, theoretically at some time, the AP must be paid, but for now, I’m calling it free cash flow.

Using the scenario where profit margins grow to 7% and Amazon grows at a rate of 1% faster than Wal-Mart did from 1995 to 2009, the below graph shows how each of Amazon’s FCF components will grow until 2023.

The net present values (NPV) of each of the above cash flows along with the total internal rate of return (IRR) are as follows:

If Amazon grows at the same rate as Wal-Mart over the subject period and sees profit margins constant at 5%, then the below values apply:

A 12% discount rate was used because it is approximately the market average return over the long haul. Amazon has proven their ability to generate revenue growth so they are no more risky than the market, and you could argue that they are less risky given their recent revenue and FCF growth in the face of the “Great Recession.” Due to the long projection period used in the above analysis, the valuation risks reside in the underlying assumptions of this DCF model. In the end, it is not about selecting the precise discount rate, but rather a reasonable one given the risks.

Based on the above, Amazon could be undervalued by $10B to $30B. If you don’t believe stock-based compensation should be included due to dilution effects (and my very liberal compensation policy assumptions), then Amazon is could be anywhere from fairly valued to $20B undervalued.

In my opinion, it comes down to this: Do you think Amazon will grow faster than Wal-Mart did and will they improve profit margins? I think they will be able to grow faster than Wal-Mart did, simple because they don’t have to physically build stores. Their expansion is virtual. It is faster and requires less capital. As for profit margins, perhaps with scale and e-books they can be improved, but this is less clear.

With stock-based compensation and changes in working capital contributing almost half of today's FCF, the quality may be less than desirable, but Amazon's potential future cash flows look solid. Based on DCF valuation, it looks as though a P/E of 70 could reasonably be justified, but today's market price offers a risky entry point for new investors.

Full disclosure: The author holds no positions in any stocks mentioned in this article

Comments

[Shabba:]

Interesting analysis. I've never valued a stock like this before. Are you saying that it is undervalued because the results of your analysis give an IRR of 17 or 13.9 and the market discount rate is 12, meaning that the company returns higher than the market and is therefore undervalued?

It seems like with long projection models you can argue any valuation though. It seems unlikely that growth rates will be high for economic reasons and the fact that Amazon is mature and so is the internet. But it is possible I guess.

It does seem strange to me that other similar high-tech internet based companies that have similar earnings growth (apple or google for example) aren't valued nearly as richly. I guess everything isn't logical.

Nov 03 01:11 PM

[Shabba:]

Should also say that I am short the stock now. I just don't see the earnings growth or the economic environment to value a stock so highly.

Nov 03 01:13 PM

[Stefan Sida...:]

It is all about having a "margin of safety"

My results say that AMZN might be fairly valued, and possibly undervalued. I would rather wait till the stock looks moderately to highly undervalued before jumping in.

The IRRs would be your expected long-term returns if either of those scenarios actually came true.

Like you said, it is difficult to project performance out this far with any accuracy. All we can do is either crank up the discount rate, change assumptions up and down, or demand a significant discount to the model's output (margin of safety).

I have thought about shorting AMZN in the past and glad I didn't. Would have been fighting the market momentum and a good company. You have the market momemtum with you now, but keep in mind that AMZN is a very good company with the illusion of having an overvalued stock price. I would rather short an overvalued bad company in a bad market. Good luck with your short.


On Nov 03 01:11 PM Shabba wrote:

> Interesting analysis. I've never valued a stock like this before.
> Are you saying that it is undervalued because the results of your
> analysis give an IRR of 17 or 13.9 and the market discount rate is
> 12, meaning that the company returns higher than the market and is
> therefore undervalued?
>
> It seems like with long projection models you can argue any valuation
> though. It seems unlikely that growth rates will be high for economic
> reasons and the fact that Amazon is mature and so is the internet.
> But it is possible I guess.
>
> It does seem strange to me that other similar high-tech internet
> based companies that have similar earnings growth (apple or google
> for example) aren't valued nearly as richly. I guess everything isn't
> logical.

Nov 03 03:05 PM

[User 432133:]

How did your assumption for stock based compensation factor in your DCF? If you're doing a FCFF DCF analysis you would assume that you buy out the entire enterprise, thus all the incremental stock based compensation will be nil (no more share based comp because there are no more shares in a private ownership). If that's the case, SG&A expense will increase and lower AMZN's cash flow per year.

If you insist on incorporating stock based comp, then you must also project share dilution for your exit value.

Nov 05 01:55 PM

[Stefan Sida...:]

Good comment and I agree with you.. This is a true expense to the owners of the company (public or private), which is one reason I calculated the NPVs separately.
In researching ESOs and FCF, I found many conflicting opinions among analysts and academics on how to treat them wrt valuation. In the end I left it in but calculated it separately so readers can include or not include it as they wish.
I don't agree with you on increasing the SG&A expense since it is already accounted for, IAW GAAP, on the income statement. Also, there can be shares and stock options in a private company, but the employees receiving them will probably want an exit strategy on the horizon (eg. IPO or buy-out).

WRT projecting dilution - Yes, I agree, but it is probably much easier (and more accurate) to not add ESO back into FCF and avoid estimating dilution over an extended period into the future (which is what you were implying).

On Nov 05 01:55 PM User 432133 wrote:

> How did your assumption for stock based compensation factor in your
> DCF? If you're doing a FCFF DCF analysis you would assume that you
> buy out the entire enterprise, thus all the incremental stock based
> compensation will be nil (no more share based comp because there
> are no more shares in a private ownership). If that's the case, SG&A
> expense will increase and lower AMZN's cash flow per year.
>
> If you insist on incorporating stock based comp, then you must also
> project share dilution for your exit value.

Nov 05 04:22 PM

[thrader:]

Well written post Stefan

I do however believe there is an element of "naivety":

"In my opinion, it comes down to this: Do you think Amazon will grow faster than Wal-Mart did and will they improve profit margins? I think they will be able to grow faster than Wal-Mart did, simple because they don’t have to physically build stores. Their expansion is virtual. It is faster and requires less capital. As for profit margins, perhaps with scale and e-books they can be improved, but this is less clear."

Indeed this goes bothways! It'll be significantly easier and cheaper for the competition to take a slice (or multiple slices) of this lucrative market. I think Google is a very good example of that. In the UK there are now quite a few online book stores who have taken significant market share from Amazon. One being thebookdepository who ships books free of charge worldwide regardless of the amount you spend.

I am afraid it is only in the US one can see fantasy PEs being "traded" as the appetite for risk simply is limitless, a bit like chineese, hence the fat cats in Wall street milking the main street day in and day out.

Also with online trading retailers, it'll only take a bad big headline like "10M customers' bank details have been hijacked" to see the sale plummet and perhaps never return to that company again.

I am a trader so I put emotions aside, but from a TA point of view this stock is way over baked and I have been shorting it this week. I could be wrong and stopped out, but as a trader you'll have to follow your trading instincts. In my view we'll soon see a drop down to 90-100.

Best wishes
Ashley


On Nov 05 04:22 PM Stefan Sidahmed wrote:

> Good comment and I agree with you.. This is a true expense to the
> owners of the company (public or private), which is one reason I
> calculated the NPVs separately.
> In researching ESOs and FCF, I found many conflicting opinions among
> analysts and academics on how to treat them wrt valuation. In the
> end I left it in but calculated it separately so readers can include
> or not include it as they wish.
> I don't agree with you on increasing the SG&A expense since it
> is already accounted for, IAW GAAP, on the income statement. Also,
> there can be shares and stock options in a private company, but the
> employees receiving them will probably want an exit strategy on the
> horizon (eg. IPO or buy-out).
>
> WRT projecting dilution - Yes, I agree, but it is probably much easier
> (and more accurate) to not add ESO back into FCF and avoid estimating
> dilution over an extended period into the future (which is what you
> were implying).
>
> On Nov 05 01:55 PM User 432133 wrote:

Nov 11 05:39 AM

[Stefan Sida...:]

Ashley,

Wrt the Walmart comparison. I did not mean to imply that AMZN would grow at the same rate, but I was looking for a yard-stick to measure them against. Obviously if you expect them to grow faster, then the valuation goes up. Same holds true for margins.

Right now, I think AMZN is somewhere around "fairly valued" by DCF as compared to WMT, but that implies you will be happy with with lots of volatility in return for a 12% or 13% return over the next 14 years. I would prefer a much larger margin of safety.

Again good luck with your short. See my previous comment on this.

Stefan


On Nov 11 05:39 AM thrader wrote:

> Well written post Stefan
>
> I do however believe there is an element of "naivety":
>
> "In my opinion, it comes down to this: Do you think Amazon will grow
> faster than Wal-Mart did and will they improve profit margins? I
> think they will be able to grow faster than Wal-Mart did, simple
> because they don’t have to physically build stores. Their expansion
> is virtual. It is faster and requires less capital. As for profit
> margins, perhaps with scale and e-books they can be improved, but
> this is less clear."
>
> Indeed this goes bothways! It'll be significantly easier and cheaper
> for the competition to take a slice (or multiple slices) of this
> lucrative market. I think Google is a very good example of that.
> In the UK there are now quite a few online book stores who have taken
> significant market share from Amazon. One being thebookdepository
> who ships books free of charge worldwide regardless of the amount
> you spend.
>
> I am afraid it is only in the US one can see fantasy PEs being "traded"
> as the appetite for risk simply is limitless, a bit like chineese,
> hence the fat cats in Wall street milking the main street day in
> and day out.
>
> Also with online trading retailers, it'll only take a bad big headline
> like "10M customers' bank details have been hijacked" to see the
> sale plummet and perhaps never return to that company again.
>
> I am a trader so I put emotions aside, but from a TA point of view
> this stock is way over baked and I have been shorting it this week.
> I could be wrong and stopped out, but as a trader you'll have to
> follow your trading instincts. In my view we'll soon see a drop down
> to 90-100.
>
> Best wishes
> Ashley

Nov 11 08:21 AM