True or false: Amazon.com (AMZN), trading at more than 70 times estimated 2012 EPS, is overvalued.
The popular answer: Are you nuts? Of course it’s true!
The correct answer: Maybe it is, or maybe it isn’t. It all depends on how much growth the company can achieve within a reasonable time frame.
One of the most absurd dichotomies in the investment community is the one between growth and value. In truth, there is no dichotomy. Growth and value are as bound as yin and yang. Follow one style while ignoring the other makes for great soapbox rhetoric, and at times, great Seeking Alpha copy with a strong likelihood of a lengthy and heated discussion in the comment section. But from an investment standpoint, it makes no sense.
Ultimately, the price you pay for a stock is reasonable or unreasonable based on what you get for your money.
In most walks of life, this is so obvious as to require no discussion at all. There’s a reason why people pay more for a high-end Mercedes than for a Toyota Corolla. There’s a reason why people pay more for a meal at a Michelin-ranked restaurant than at Applebee’s. There’s a reason why people pay more for apparel purchased at Brooks Brothers than at Wal Mart. Why , then, when it comes to stocks, do people actually consider looking at price alone (or even valuation metrics, like P/E, alone) without giving serious thought to the nature of the company (partial ownership of which constitutes the thing you purchase?)
Over the course of the past generation, the investment community has added a metric that would seem to address this issue: PEG, or the ratio of P/E to Growth. This is, actually, a pretty good metric in that it opens value investors up to looking in, in a non-dismissive manner, at high-P/E companies to see if the ratios are justified. That’s what we want to be doing. Yes ... really. We need to be looking at growth. That’s what separates stocks from fixed income. (I didn’t make this up. Growth assumptions are built into the classic dividend discount model as endorsed in the classic Graham & Dodd text.)
The problem with PEG in everyday use is that there really is no objective basis for determining what constitutes a reasonable PEG. Folklore tells us it should be 1.00 or less (i.e. that we can pay up to 30 times earnings only if the EPS growth rate is at least 30%). You could do a lot worse than to follow that principal, but that doesn’t change the fact that it is based strictly on folklore and can lead you to miss out on a lot of stocks you really ought to have been considering. We have no real, objective way of determining if the maximum PEG really needs to be 1.00, or 1.25, or 2.00.
A Valuation Methodology
I’m going to apply some basic algebra to twist the factors around into a form that will help us focus our thoughts on the issues that will, ultimately, make or break a stock. I’m going to work with AMZN and instead of deciding how much of a P/E I should accept today, I’m going to calculate a “required” EPS growth rate; the minimum EPS growth rate the company needs to achieve in order to justify investment at today’s stock price. Once I have that number, I can decide how comfortable I am with it and, if I want, use business/market precedent to help fortify my decision one way or the other.
Here’s a simple procedure:
1. Start by determining how much of an annual return I’d want to achieve over the next four years (the mid-point of the 3- to 5-year time horizon typically cited by investors who like to think long term) through stock ownership. To organize my thoughts, I’m going to use the capital asset pricing model, which tells me that a required annual return should be the “risk free” interest rate plus an assumed equity-risk premium multiplied by a stock’s beta (the measure of volatility relative to a benchmark, the S&P 500 being the most popular one nowadays). For risk-free rate, I’ll use the 10-year treasury rate, now about 2%. For equity risk premium, I’ll use 4%, a figure used by many. Amazon’s beta is 1.14. Putting that together, I get a required annual return of 6.56%. (Does that seem too low for your taste? Don’t worry; I’ll circle back to it later.)
2. Next calculate your required four-year stock price. This isn’t a target price, a prediction of where you think AMZN will trade. It’s a minimum threshold. If you don’t think AMZN can actually trade at least that high, you would not bother buying. A 6.56% per year rate of growth compounding out four years means I would need a total gain of 28.94%. That means AMZN would have to fetch at least $303 per share (28.94% above its current $235 level) to warrant consideration.
3. Decide what P/E you think the market might award the stock four years hence. Here’s a good opportunity to get tough with the stock. AMZN now trades at more than 70 times estimated next-year’s EPS. I’m not willing to assume Mr. Market will continue indefinitely to be that generous. I’m going to assume the P/E will, over the next four years, work its way back down to earth. I’ll assume 25.
4, Now, we can calculate how much EPS Amazon would need to generate four years hence to make all this work. We take the future price threshold of $303 and divide by 25 to get $12.12 per share.
5. Finally we come to the punch line: What sort of EPS growth rate must Amazon achieve? If you use Excel or a decent handheld calculator, you can get your answer in less than a minute. The future value is 12.12. The number of periods is 4. The present value is $2.07 (the consensus estimate of 2011 EPS). The answer, the annual growth rate that connects the dots, is 55.6%.
Stop! Don’t trade yet. This is the stock market, which is part of our uncertain and ever changing real world. It’s not a simple math exercise.
The Fun Part
I strongly recommend using Excel to implement this methodology (see Appendix below for instructions on setting up a template) because you’re not going to want to blindly accept the number “as is.” We need to play around with some what-if alternatives and for that sort of thing, Excel is as good as it gets.
First is the required return. Yeah, yeah, I know I could probably get a bus full, perhaps two or three busses full, of academics who’ll say I did it right and that 6.56% a year is a reasonable target. My gut tells me otherwise. I’m going to double the risk-free rate to 4% (I’ll pretend I can find something secure that will give me such number, if not today, at least a few months from now). I’m also going to toss out AMZN’s historical beta and plug in a much, much higher 2.00 figure to reflect what I expect will be increasing volatility as the investment community emotes over every news item relating to the revamped Kindle line. Now, my required annual rate of return comes to 12%. That raises the required growth rate from 55.6% to 63.5%.
What about the EPS number I used as a present value? We’re already near the end of the third-quarter of 2011, and analysts should have pretty good visibility regarding 2012. Suppose I use the $3.33-a-share consensus 2012 estimate. Since I’m going out a year in terms of the start, I’ll cut the time horizon from four years to three. As it turns out, the reduction in time frame has a bigger impact. The required growth rate is now 64.4%. If I use a three and a half year period, the required growth rate comes to 53.1%.
I could go on (we could assume the P/E will take longer to recede and use, say, 30 instead of 25), but I think you should be getting a sense of what Amazon needs to deliver to make the stock a Buy at the current price. Without attempting to get too precise (something we must always guard against considering the fact that nobody can really know the future), it looks like our attitude toward the stock should depend on whether we think Amazon can deliver a few years’ worth of annual EPS growth in the 50%-65% range. One who would answer in the affirmative can buy AMZN and easily stare down critics who cry “overvalued.”
The End Game
Of course the question du jour, whether Amazon can grow as briskly as we’d require given the current stock price, is not an easy once to answer. That’s understandable. Did you really think successful value investors get the big bucks simply by noting that P/E ratios are low? Anybody who graduated first grade can do that. Successful value investing, like everything else, requires you to work for your money and working for your money means assessing and understanding the “merchandise” you’d get if you choose to pay what sellers ask for AMZN. Specifically, you need to think about the growth prospects. You don’t need an actual estimate; in other words, you need not argue whether a proper number is 50% or 70% or 62.3%, etc. All you need is a comfort level as to whether the company can meet or beat the sort of targets articulated here, or in an alternative exercise if you choose to change if-then assumptions.
That is the bread-and-butter of value investing. It’s not that successful value investors ignore metrics. It’s just that getting the information takes five minutes at most even if your Internet connection is running badly. The rest of the effort is devoted to company analysis and if you read a report or article dealing with valuation, hopefully, the writer is focusing mainly on the company.
So what about AMZN? It’s tempting to dismiss the stock saying there’s no way in heck the company can come close to those thresholds. But be careful. Many who claim to be value investors spend a disproportionate amount of time looking at lackluster companies because those are pretty much all they’re ever going to see if they start with a preconception that the P/E has to be low (akin to the car buyer who insists the price must be less than $20,000 and finds himself looking at nothing but stripped-down low-end choices). That can distort one’s perspective. Value investors don’t have to restrict consideration to corporate dregs and if they choose to look at more exciting opportunities, they’ll need to apply the correct framework.
What sort of growth rates might we expect from companies in the midst of vigorous expansionary phases. It’s hard to say, but it helps to consider precedent.
Apple (AAPL), as it launched out iEverything, delivered a 58% annual rate of EPS growth between 2005 and 2010. The analogy isn’t perfect. Apple’s hardware business was a bigger portion of its total than is the case for Amazon. Then again, hardware profits from the Kindle line aren’t the point, assuming they even exist. Kindle is about driving content sales, directly for consumption via Kindle and in an ancillary manner for everything else. (Once an Amazon Prime member is attuned to Amazon.com for books or videos, it would seem natural to stay or go there for other kinds of purchase orders as well.) There’s also the prospect that e-commerce (where Amazon is King) is nowhere near the point of maturity. Given the cost and competitive pressures in retail, together with a pickier consumer, do you think brick-and-mortar retailers are going to find it harder or easier in the years ahead to maintain proper levels of customer service and in-stock positions? Search Best Buy (BBY) on Seeking Alpha and see how many references there are in articles and comments about browsing at Best Buy and placing orders on Amazon. Heck, my local supermarket stopped stocking my dog’s favorite treats so now I routinely order via Amazon. Note, too, how many purchases are actually from Amazon; this company has, actually, become quite a large fulfillment organization serving a gazillion smaller merchants who can’t really maintain serious e-commerce platforms on their own.
On reflection, the Apple precedent may not be crazy. Indeed, Amazon spent a ton building a powerful customer service and support organization (with critics whining and bashing CEO Jeff Bezos every step of the way) and has only recently crossed the threshold of turning customer love into EPS growth. Amazon may not be exactly where Apple was in 2005, but it may be in the general ballpark, albeit with a different business model.
Just for fun, let’s now compare Amazon to a recent growth story that I loved (ignoring the value police who ranted every step of the way up about metrics) ... .Green Mountain Coffee Roasters (GMCR). I took my profits already, but still find it interesting to watch GMCR as an example of how emerging growth can translate to numbers. In 2007, 2008 and 2009, respectively (after it had acquired and integrated Keurig), EPS growth rates were 45.7%, 63.5% and 140.1% respectively. The company slowed to 27.5% in 2010, but in the trailing twelve month period, EPS growth came in at 108.4%.
There are other situations you can look at. Research In Motion (RIMM), a company whose future now seems quite uncertain, did far better in its glory days than we’d need Amazon to do going forward. eBAY (EBAY), too, has had quite a few stretches like this. Ditto Google (GOOG) and Priceline (PCLN).
None of the analogies are perfect, and some less so (i.e. RIMM) than others. But one credible thing does seem to be emerging. It’s not out of line to think a company building up a new consumer business as posting EPS growth rate in line with what the Amazon stock price requires the company to deliver. This isn’t a complete analysis and I haven’t yet decided whether I want to be in AMZN. (In particular, I plan to think a lot more about my assumed future P/E.) And I certainly don’t want anybody to read this article and then buy AMZN. My hope is that some of you will create the Excel template illustrated in the Appendix (it’s really very simple), get a sense of how this sort of analysis is conducted, and then do your own thing, with AMZN or any one of countless other stocks that come to your attention. (There are lots of sites you can use to get the necessary information, Yahoo Finance among others will suffice.)
I do want to drive home the point that there is no law saying value investors have to stand apart from AMZN or other interesting situations of this sort.
Is this uncertain? Heck yes! Is it more uncertain than bottom fishing in distressed companies like Bank of America (BAC) or cyclically depressed builders like Toll Brothers (TOL). I can’t speak for you and you can’t speak for me. But I can speak for myself and I’ve sweated enough over the years over more traditional value-type plays to say those can be every bit as difficult to analyze properly as the AMZNs of the world.
And to the extent I think Amazon is fair game for value investors, I do have at least one big-name ally, William Miller, the big-name value superstar who went early into Amazon based on his assessment of cash flow growth prospects. Yes, it has been popular to bash Miller lately since his funds have had struggles of late (although most recently, Warren Buffett seems to be getting an increasing share of verbal drubbings). But putting childish carping aside, if, when all is said and done, I can be a dud like him, I’ll sign up for it.
This should be sufficient to help you build your own Excel template is you’d like to do this sort of analysis.
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