Amazon (NASDAQ:AMZN) sometimes gets a lot of flak for not focusing its efforts in driving bottom line expansion, but recent moves to raise prices at Prime speak to a renewed focus on offsetting growing expenses. We think Amazon is one of the best examples to use to explain the importance of using a discounted cash flow model in valuing equities. For one, Amazon's price-to-earnings and even its price-earnings-to-growth ratios are largely meaningless. Let's walk through Amazon's valuation through the lens of a DCF and run shares through the Valuentum style of investing.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolio. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Amazon posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. Though most onlookers would agree that from a relative value standpoint, shares aren't very attractive. However, from a DCF standpoint, we think they are fairly valued. In any case, there are other ideas that register higher ratings on the Valuentum Buying Index, and we would point investors to those ideas, many of which are included in the Best Ideas portfolio. With that said, let's dig into Amazon's report.
Amazon's Investment Considerations
• Amazon.com earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 45.5% during the past three years.
• Amazon operates as an online retailer. The firm seeks to be a customer-centric company for four primary customer sets: consumers, sellers, enterprises, and content creators. The company also provides advertising services and co-branded credit card agreements. Amazon may look a lot different than it does today in 10 years.
• The online retailer continues to focus on taking market share and damaging its competitors, rather than generating large accounting profits. The Kindle Fire HD, a tablet that sells for roughly breakeven, is a top-selling product on Amazon.com. Recent events such as raising prices on Prime members, however, indicate that profit growth won't be completely ignored.
• Amazon.com's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.
• Amazon seems mostly satisfied with growing revenue and making new products. Free cash flow should improve if investments turn out to be profitable, but the company remains a low-margin operation.
• We think one of the most important takeaways from the DCF application to Amazon's shares is just how sensitive its business model is to changes in the operating margin. We estimate that for every 1 percentage point adjustment in a mid-cycle operating income margin forecast, it results in a $50 per share delta of the company's fair value. Due to Amazon's large sales base, the company has tremendous operating/earnings leverage.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Amazon.com's 3-year historical return on invested capital (without goodwill) is 45.5%, which is above the estimate of its cost of capital of 10.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Amazon.com's free cash flow margin has averaged about 2.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Amazon.com, cash flow from operations increased about 40% from levels registered two years ago, while capital expenditures expanded about 90% over the same time period.
Understanding Amazon's Cash Flow Generating Potential
To help convey Amazon's cash flow generating potential, let's take a look at its cash flow generation in previous years.
(2) Free cash flow, a non-GAAP financial measure, is defined as net cash provided by operating activities less purchases of property and equipment, including capitalized internal-use software and website development, both of which are resented on our consolidated statements of cash flows.
Image Source: Amazon
What the image above tells us is that when or if Amazon starts to focus on profitability, its potential free cash flow generating capacity is tremendous (the bottom line in the image above). We believe this fact of Amazon's business model is what many investors may have a difficult time acknowledging with respect to the company's current share price. Amazon is not trading at such lofty levels because the market is crazy, but instead, it is trading at such lofty levels because the market acknowledges its fantastic cash flow generating potential in the future. This dynamic is a fact of valuation: a fair value estimate of a company is based on future expected free cash flows, not current earnings or even next year's earnings.
Our discounted cash flow model indicates that Amazon.com's shares are worth between $236-$393 each. Shares are trading just shy of $300 each at the time of this writing. As you may have gathered, the firm's large fair value range is driven by the sensitivity of Amazon's fair value estimate to its operating margin. Even small changes in the company's mid-cycle (Year 5) operating margin can have large changes in the company's intrinsic value. We think an operating margin focus at Amazon will work wonders to generating even more value for shareholders, even as CEO Jeff Bezos says a focus on operating margin dollars is appropriate. On a more technical level, the margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $314 per share represents a price-to-earnings (P/E) ratio of about 532.9 times last year's earnings and an implied EV/EBITDA multiple of about 33.7 times last year's EBITDA. Though many will say that these are lofty and unreasonable multiples, the company's intrinsic value is supported by its discounted future free cash flows and the firm's net balance sheet impact.
Our model reflects a compound annual revenue growth rate of 20.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 29.6%. We think this is more driven by the "law of large numbers" than any absolute deceleration in the pace of expansion. Our model reflects a 5-year projected average operating margin of 3.1%, which is above Amazon.com's trailing 3-year average. If Amazon achieves a long-term operating margin even just a few percentage points higher than what we are modeling, shares can be considered significantly undervalued.
Beyond year 5, we assume free cash flow will grow at an annual rate of 6% for the next 15 years and 3% in perpetuity. For Amazon.com, we use a 10.6% weighted average cost of capital to discount future free cash flows. Given Amazon's current pace of top line growth, we think these long-term forecasts are reasonable. Its discount rate is slightly higher than the median in our coverage universe, but we think it adequately captures the uncertainty of Amazon's business model.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Amazon to peers eBay (NASDAQ:EBAY) and Expedia (NASDAQ:EXPE), among others. To no surprise, Amazon is unattractive on almost every traditional valuation "multiple" metric. Though this information should not be ignored, we think a DCF model is more appropriate in valuing shares and gauging an appropriate margin of safety.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $314 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Amazon.com. We think the firm is attractive below $236 per share (the green line), but quite expensive above $393 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Amazon.com's fair value at this point in time to be about $314 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Amazon.com's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $427 per share in Year 3 represents our existing fair value per share of $314 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.