- Amazon closed at $323, down 21% from its 52 week high of $408.06. I explore whether it represents growth valued at a reasonable price.
- The company is not universally hated by market participants and so it does not rate as a contrarian buy.
- It is a great company trading at a fair price, but falls short of representing what I see as growth valued at a reasonable price.
I spent part of January and February looking at Amazon (NASDAQ:AMZN), Facebook, Google, and Tesla - all interesting growth companies. Expensive markets provide an excellent opportunity to see where the performance is amongst growth stocks. The aim of these posts was to review the companies at a very top level through identification of past trends, and extrapolate those trends into the future, based upon potential for expansion of their key markets. A secondary aim was to establish potential price points to re-visit the stock buy decision. Since that time, I have done my homework, and would be happy to own stock in these companies at the right price. This is a very personal decision, so each investor needs to do their due diligence.
In the post on Amazon, I had said "My personal buy target would be $310 to $315 range if it ever gets there. From this level an annualized return potential of 15% is attractive. But it would be a tiny allocation: sized at a level where a loss would hurt my ego, but not my portfolio. Below $275 would deliver annualized return potential of 17.5%, at which price I would likely allocate further capital despite my hurting ego. And of course if we see a 2008/2009 like market, with Amazon trading down to $75 or lower, I would be a buyer despite the pain."
On Friday, Amazon closed at $323, after hitting an intra-day low of $315.61. And so I thought this would be a nice time to revisit Amazon: this time with lowered model risk as a result of moving closer towards consensus.
How do different market participants view Amazon?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. The model output (beta version) for Amazon can be viewed here.
This quantitative analysis of investor behavior suggests that the market is neutral on Amazon. The model indicates that the stock might be very attractive to growth investors, but is unattractive to value investors. Quality (ownership and return and profit) is negatively perceived, and momentum is plain ugly.
Source: Alpha Omega Mathematica
More specifically, the model suggests that growth and balanced investors, regardless of their capital allocation style would hold Amazon. A value investor allocating capital with no sector or industry bias would sell, as would a value investor with a sector capital allocation bias. The value investor with a bias towards allocating capital at Industry level would hold. Stock selection style agnostic investors (people who are not value, momentum, growth or balanced style investors), would hold the stock, though such investors allocating capital at sector level would be inclined to sell. Momentum style stock selectors would sell, though those allocating capital with no sector or industry allocation bias would be inclined to hold.
Source: Alpha Omega Mathematica
It is often a good time to buy growth stocks when momentum is ugly. However, the voice of the market suggests that it might be well worth waiting a bit further. If one of the capital allocation styles for a balanced stock selection style went to sell, along-with any one of the capital allocation styles for a growth stock selection style, it would be a decent contrarian buy signal.
Why look at Amazon?
Firstly, Amazon is a mega-cap stock with a market capitalization of near $150 billion. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, Amazon's beta based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards 1 is 0.95. This low beta adds additional defensive characteristics. Thirdly, Amazon as recently priced does not include potential alpha, however, it does not include negative alpha, whereas the broad market is priced to deliver negative alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks. These defensive characteristics are offset by volatility arising as a result on a shift of investor emphasis from growth to value, and as a result of the absence of defensive characteristics from a dividend.
Cyclicality and Amazon
While Amazon is broadly perceived as a technology stock, its business has a high degree of dependency on discretionary spending by consumers. In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, stocks in the consumer discretionary sector tend to underperform. You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance today I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync, with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, technology is expected to underperform in late cycle conditions. But if Europe, other developed markets, or emerging markets, shift into mid-cycle conditions, which is a time when technology typically outperforms, U.S. companies in the technology sector could well outperform. Let's not forget that of Amazon's $74.45 billion in revenue during 2013, $29.9 billion (40.2%) came from outside North America.
Analyst price expectations
Recently Amazon traded at $323.00. From Yahoo Finance we know that thirty-nine analysts expect an average price target of $433.87 (median $440.00), with a high target of $500 and a low target of $330. This is a pretty wide dispersion in expectations. The wide dispersion in high and low price estimates suggests that the risk is somewhat high. So far the bears have it. And that might just present a good opportunity to buy growth valued at a reasonable price. At $297 the price would be 10% below the low analyst price target.
As I mentioned earlier in this post, it is often a good time to buy growth stocks when momentum is ugly. However, the voice of the market suggests that it might be well worth waiting a bit further. In the section where I ran through how Amazon is perceived by different market participants, its attractiveness was reviewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in-line with our expectations.
Mathematically, the worth of Amazon is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 0.95, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 0.95 differs from the beta you will see in other places because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Amazon, we should be targeting a long-term return of 9.9625%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. The problem is that Amazon does not make money. From Yahoo Finance we know that for 2014, forty analysts expect mean earnings of $1.93, with a high estimate of $3.74 and a low estimate of $0.62. For 2015, thirty-six analysts expect mean earnings of $4.24, with a high estimate of $9.00 and a low estimate of $1.84. In respect to sales, for 2014, forty-five analysts expect mean sales of $89.88 billion, with a high estimate of $92.84 billion and a low estimate of $87.86 billion. For 2015, forty analysts expect mean sales of $107.59 billion, with a high estimate of $117.46 billion and a low estimate of $102.75 billion. It is clear that growth expectations are strong. And in fact on Reuters you can see analyst expectations for long-term (five-year) earnings growth are at 49.79%, with a high estimate of 88.70% and a low estimate of 25%. From Reuters we also know that the capital spending growth rate over the past five years has been 59.56%, and I think we can agree that growth comes from investment.
My take on Amazon's earnings is very bullish despite their absence. During 2013 they took in revenue of $74.45 billion. They made no money. Their capital spending, aggressive pricing in retail markets, low priced delivery, and investment in expansion in global markets represent a huge investment in growth. If they chose to focus on profit, while compromising on growth, they could have earned $5.58 per diluted share: this represents a 3.5% net margin on sales for 467 million diluted shares outstanding. This net margin is on the low side of retail industry margins globally. Thin margins are the nature of their business, and thus while they continue to drive growth, expect to defer profits to tomorrow. Of late, Amazon has raised prices on Amazon Prime, and they have introduced Amazon Dash to drive grocery sales. One represents some commitment to making money, while the other represents continued commitment to growth. The chart below shows the earnings trend over the past decade, together with analyst estimates for 2014 and the coming three fiscal years. I will go with sustainable EPS estimate of $3.87, which represents the 2015 earnings estimates discounted at a 9.625% rate for one year. It is a considerable discount to the $5.58 in earnings I believe they could deliver today if they chose to stop investing in aggressive growth, because I don't believe they will, and I don't believe they should.
This chart shows the historic trend on sales together with expectations for the current and coming fiscal years. That upward sloping line means something very nice for the future, despite the frustrations today.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends, buybacks net of dilution, or growth at premium to market growth rates. I expect Amazon will pay out approximately 48% of earnings dividends, buybacks, net of dilution, or growth at premium to market growth rates over the long term. This 48% estimated adjusted payout ratio could be substantially higher if Amazon is able to enjoy a high return on equity as I expect it will.
If we use a very long-term growth expectation of 9.334%, Amazon is worth $323. Amazon Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 109.334% * $3.87 * 48% / (9.9625%-9.334%) = $323.00. At this price it is likely that an investor with a return expectation of 9.9625% will be satisfied.
The growth estimate implied by the current market price of 9.334% is acceptable. If we work with a 25.91% four-year growth rate, we arrive at an estimate for 2017 of $9.72. This estimate does look aggressive, but it is not when you consider the consensus estimates on YCHARTS for 2017 are at $11.87. Nor does it look so outlandish when viewed in the context of potential earnings being in the region of 3.5% of revenue. In getting to the 9.334% long-term growth estimate, I have assumed 25.91% growth for the coming four years. After four years, I have assumed that the growth rate will fall back to an 8% growth rate, in-line with potential real Global GDP growth of 4.2%, and global inflation of 3.8% for the next forty-six years. This gives a composite very long-term fifty-year growth rate of 9.334%. By computing this composite fifty-year growth rate we are not suggesting that growth will decline to 8% in the fifth year: we are simply implying that we are willing to pay a premium for the next four years' growth, after which as long standing shareholders, we would expect to participate fully in growth rates which run at a premium to market growth rates. Thus while Amazon does present an alpha opportunity from growth to market growth premiums, it is too far into the future to consider.
An investor can expect long-term returns of 9.9625% from Amazon as priced. There is no potential alpha. But yet there is opportunity for abnormal long-term returns, with risk. If we accept $107.59 billion as a reasonable estimate for revenue in 2015, and work with a 3.5% net margin to estimate earnings, we arrive at an earnings estimate of $3.77 billion. Assuming a dilution rate of 1.5%, the diluted share count rises from 467 million today, to 481 million by end 2015. And we have potential earnings per share of $7.82. If at end 2015, the five-year growth rate expected is 17.50%, we get a composite 50-year growth rate of 8.91%, assuming growth in the sixth year onwards drops to 8%. In this situation, the stock could be worth $390 [= 108.91% * $7.82 * 48% / (9.9625%-8.91%)], and will have received an annualized return of 11.50% for the period from April 4, 2014 through December 31, 2015.
A tiny allocation: sized at a level where a loss would hurt my ego, but not my portfolio at $310 to $315 would have been acceptable now. But all told, I am being greedy and fearful too: I want Amazon cheaper, because in my view it does not represent growth valued at a reasonable price at present. But it's getting close: at below $278 it represents good value. At closer to $225 the value case becomes compelling as the growth risk premium (the difference between investor return expectations and very long-term growth expectations) is sufficiently wide. I am fearful too, because growth stocks have been whacked of late, and I am scared of jumping in too early. The blood does not flow thick and fast on the street just yet: I will be listening carefully to the voice of the market to make a buy decision.
The post is done - this is an explanatory note
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas, which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is long-term return expectation minus long-term growth rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very-long term, the growth risk premium has tended toward 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings
3. When you look at long-term growth rates, remember it is not the next years' growth or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rates for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I'm willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.