Should Amazon Be Trading At Such A High Valuation?

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 |  About: Amazon.com, Inc. (AMZN)
by: MarketWizard

Summary

Is a forward P/E of 100x justified when U.S retailers are trading near 15x and high-end tech companies trade in a range of 15-35x?

The case for a high valuation can be made for companies enjoying high operating margins. Amazon, on the other hand, has a profit margin of just 0.5%.

There is a lot of competition from smaller retail start-ups, but Amazon's massive R&D budget for the last many years has given it a competitive moat that warranties premium valuation.

If you're reading this, then you're probably asking yourself the same question that most industry analysts have been asking for some time now: Is Amazon (NASDAQ:AMZN) stock headed for a severe cutting-down-to-size by market forces?

Why is this question being asked? Because Amazon isn't making enough profit. This might sound like a surprising answer for a very successful company, but the key word here is "enough." Amazon's price-to-earnings ratio has never quite been justified by the online retailing giant's profits. You see, the company might have survived the dot-com bust of 2001 because it had provided a solid revenue stream for its shareholders, but that solid bedrock made investors have the sort of irrational exuberance about Amazon stock that continues until this day.

What sort of exuberance? Well, yesterday's calculation for the company's P/E was a whopping 515x. Its forward P/E multiple is 100x too. Even if we were to buy the argument that we shouldn't compare Amazon's shares with stocks of other old economy companies, which haven't much new ground to cover, but with other tech firms instead, the ratio is still staggeringly high. To put it into context, Apple's (NASDAQ:AAPL) P/E comes down to 15x; Google's (GOOG, GOOGL) to 28x. Even Facebook (NASDAQ:FB), a company that a number of analysts say has its best revenue days ahead (and hence justifying a high share price despite low earnings) comes down to 35x. In comparison, Wal-Mart (NYSE:WMT) trades at a P/E of 15x, the average of the US retail industry as well.

Amazon's problem

But why, the discerning reader would ask, does Amazon, one of the largest retailers in the world, not have enough profits? Well, to begin with, one could start comparing it with the brick-and-mortar retailing behemoth, Wal-Mart. The latter is famous for its "race to the bottom" as far as prices are concerned, but even its margins are 3.36 percent. Amazon, on the other hand, is doing its thing at half-a-percent of profit margin. Why does it have such little margins? Well, Amazon has a lot of expenditures, like splurging on R&D, for instance, which went to the tune of a whopping $6 billion last year. Even for a tech company, that is no small change. But Amazon is, we're looking at the bottom line, a retailer. An R&D budget of that size is pretty much unheard of in this line of work.

But then again…

Of course, there are arguments from the other end as well. Consider the issue of the R&D budget. Those investors that aren't squeamish about Amazon's stock say that if one were to deduct this huge figure from expenditures, the company's margin would have been 8 percent, which is more than comfortable given its scale of operations. And then there is the future dividend from the products developed after the $6 billion splurge that has to be factored in as well. Furthermore, such a large figure may be abnormal for a retailer, but not so for a tech company. Amazon has spent 8 percent of its sales on research. Google, at $8 billion, has spent 13.4% of sales; IBM's $6.2 billion is around 6% of sales.

Such expenditures cover the spectrum of reasonable to extravagant, based on which sector one would want to slot Amazon in.

Well, what is it?

Amazon's price-to-earnings ratio is undeniably high. It can be justified by thinking that company can make huge profits in the future and that its growth rate is going to be similar to the one it has been seeing in the past fifteen years. Other analysts say that the honeymoon period for Amazon, one of the longest in tech history, is looking to end; that the market for Amazon stock would finally settle down to an efficient, much lower equilibrium that other blue-chips eventually do. It's not as if those boring price-to-earnings ratios are only reserved for old economy sectors like chemicals and automobiles. Cisco (NASDAQ:CSCO), another tech company with solid fundamentals, has fallen down to the stable teens from dizzying three-digit heights.

True, Amazon forayed into other territories, like being a hardware manufacturer (Kindle), and a pretty successful one at that, and also an entertainment content producer. But retail is still its mainstay. With a host of small online retailers, all of them lean and hungry, competing for the same pie, not to mention gargantuan companies like Alibaba bringing the war home to Amazon, the latter would cease to be the growth story it once was.

Amazon is a company with solid fundamentals and a stable, solid revenue stream. Its stock is just a little - ok, not just a little - overpriced.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.