When trying to value companies, many people, and rightly so, think that earnings are the only thing that matters. For most companies, this is true. If the company earns more, the stock price goes up. But historically, this isn't the case for every stock, and it really depends on the sector the company is in. Remember in the late 90s and 2000 when all those internet stocks shot up? They had no earnings. In fact, they had little to no revenue either. They were trading on price to clicks, or page views. When the bubble burst, those that didn't have earnings fell apart. Price to clicks was a good valuation metric in theory, but not for the long term.
Now when we think of retail companies, price to sales is a good valuation metric. We want our retailers to have more sales each year, and sometimes we can forget about how much money they actually make, if they are even profitable at all. That is where today's focus comes in. Amazon (AMZN) is a great case study on why earnings don't matter. The company, which recently rolled out its Kindle Fire tablet, has seen its stock jump about 30% this year despite the projection for income to drop more than 50%. Why? Because revenues are expected to rise by over 40%. For now, the company is trading on revenue growth, and not earnings growth. This is why the P/E multiple has blown out so much, which has caused a lot of concern lately.
Amazon doesn't make a lot of money on the products it sells. It's overall margins are quite low, as you can see from the following table. Now, we don't know exact numbers, but the general consensus is that Amazon sells its Kindle products at a loss, expecting to make the money up when customers buy other products with it, such as higher margin e-books.
*Projected based on current EPS and Revenue estimates, along with most recent quarter number of shares outstanding.
Now, to be fair, analysts estimates for this year have come down from $1.95 to $1.20 since Amazon's latest quarterly report. But even at $1.95, projected net margins for this year were only estimated to be 1.82%. That's a 50% drop since 2009, and that's before the lower EPS numbers. Amazon's margins have been contracting for the past two years, and that will continue for the near future. Now let's take a look at Amazon over the past few years. The price number you will see below is the average daily closing price throughout the year. 2011 data is as of last Friday's close.
Do you notice that Amazon's net income for 2011 is projected to be at a level that's down about 8% over that of 2004? However, shares have gone from $43 to almost $200. That's due to the revenue growth. Here's how the valuation looks.
Amazon is earning less per share now than it did in 2004. Next year's current estimate is equal to that of 2009, and yet the stock is twice the price. Now, if you have read any of my recent articles on Amazon, you'll notice that I've been really alarmed by Amazon's Forward P/E, which currently is around 92 and just a week or so ago was in the triple digits. Now, you might ask why I'm so concerned with the Forward P/E if earnings don't matter. Well, I'm not concerned with the actual number, I'm concerned with the recent explosive growth in that number. On July 25th, Amazon's Forward P/E (for 2012 earnings) was 56. Just minutes before it reported its latest quarter, it was at 71. Now it's at 92, and it was over 105 recently.
To be fair, the recent fall has knocked down Amazon a bit, and the Forward P/E in the low 90s is certainly better than where it was recently. However, earnings estimates have come down by a third for both this year and next. The stock price hasn't though, not yet anyway. Why? Because earnings don't matter.
For Amazon, it's all about the sales. The Kindle Fire appears to be taking some sales away from Apple's (AAPL) IPad, but remember, they aren't quite the same product. Apple's IPad is a more premium product, and its sales might be lagging now because some expect a third version to possibly come out during the first quarter of 2012. If so, expect Kindle Fire sales to be great through then, but an IPad 3 will be a great seller going forward.
As long as Amazon keeps the sales up, investors will be willing to buy this stock. Unless of course, the company starts losing money, and that is a possibility in this current quarter. Amazon is projected for 40% year-over-year revenue growth in its busiest quarter, but EPS is expected to fall to $0.20 from $0.91. A lot of that is the increased costs involve with rolling out the Kindle Fire, but remember, the company is also losing money on each unit it sells. Amazon's profits are expected to bounce back in 2012, but at current, only to 2009 levels. That's assuming the numbers don't come down any further, which is entirely possible.
So just remember, when you look at Amazon, it's all about the sales, and that's why you are paying 92 times next year's projected earnings, or $1.58 for every penny that Amazon is expected to earn this year. Because of that, I'm not ready to buy Amazon just yet. I think estimates could come down more, and I'm not willing to pay that valuation right now. I'd rather be in Apple right now, as that valuation has gotten extremely enticing. That is why I'm currently short Amazon in my model short portfolio, and have sold Amazon calls in my model options portfolio. However, a few more down days like this, and my mood on Amazon might just start to change. But for now, I'm not willing to pull the trigger. Buy Apple instead.