Performing a Bull / Bear valuation of Amazon
The Bulls vs. Bears debate has been intense lately as Amazon (NASDAQ:AMZN) missed earnings expectations for the second quarter in a row and as the company continues to spend aggressively in order to sustain 20% revenue growth over coming years. The stock is now down 16% year-to-date.
Valuing companies which deliver high revenue growth but limited short-term earnings is always a difficult task. Comparative valuations notably are not reliable as the EV/sales ratio is the single ratio that can be used. But we believe that a DCF (discounted cash flow) valuation is pretty well suited to this kind of mission as it captures the long-term potential (revenues and margins) of any company.
As a result, we have decided to perform a DCF valuation of Amazon, actually two valuations (bull case and bear case) to better assess the risk/reward. Please note that 2014-16 figures are consensus forecasts and that we have included in our model stock-based compensation. Even if stock-based compensation is a non-cash item, we consider it as a real cost.
Bull case: 16% upside
We use a discount rate of 8.5% (with a beta of 1.0x) and make the following assumptions:
- Revenues continue to grow at a double digit pace until 2022 (with a close to 20% CAGR between 2015 and 2018) and then gradually decelerate.
- In 2024, Amazon generates more $350bn revenues (vs. $91bn expected in 2014) and still delivers a solid 6% revenue growth. For comparison purposes, Wal-Mart (NYSE:WMT) is expected to grow revenues by 3% in 2015 to $490bn.
- The non-GAAP operating margin gradually recovers from the 2014 dip and reaches 7.5% in 2024, well above Wal-Mart's 6% margin. This reflects the operating leverage of the online model vs. the brick-and-mortar model and the rising weight within the mix of services such as AWS and the nascent payment business which are likely to be more profitable.
- Growth rate in perpetuity is 2.5%, consistent with world GDP growth across different economic cycles.
We get to a $389 valuation, or 16% upside.
Bear case: 37% downside
We use a discount rate of 9.1% (slightly higher beta of 1.1x) and make the following assumptions:
- The revenue growth deceleration is steeper than in the bull case but Amazon continues to grow at a double digit pace until 2020.
- In 2024, Amazon generates $288bn revenues (vs. $91bn in 2014) and delivers 4% revenue growth, roughly in line with Wal-Mart today.
- The non-GAAP operating margin gradually recovers from the 2014 dip and reaches 6% in 2024, in line with Wal-Mart's margin.
- Growth rate in perpetuity is 2%, slightly more conservative than in our bull case.
We get to a $209 valuation, or 37% downside.
In all, we believe that the risk/reward is still not attractive for investors: a 16% upside in a bull case is not sufficient in our view to offset the significant downside risk potential.
Importantly, we believe that Amazon is still at an early stage of this investment cycle and that the group's recent expansion initiatives are likely to delay quite significantly the widely expected operating leverage. This suggests in our view that many investors could remain on the sidelines until revenue and gross profit growth starts dropping to operating income and EPS.
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.