Apple vs Amazon: A Valuation Analysis

In performing a valuation study on Amazon.com (AMZN) and Apple Inc. (AAPL) it is evident that both stocks are priced with high expectations for growth and profitability. Both trade at high P/E multiples; that doesn’t automatically signify that the two are overvalued as long as solid justifications for the high multiple can be ascertained. Decomposing the value assumptions (expectations) which are implied by the current share price, an understanding of future performance required to support the share price can be obtained.
I evaluated Amazon and Apple and made some comparisons with respect to P/E multiples and DCF model valuation. I concluded that Apple’s current valuation is reasonable based on input assumptions I believe are sensible given historical performance and growth momentum. Amazon, on the other hand, I determined it’s overvalued primarily due to my operating margin assumptions.
The key underlying factor implied in Apple’s market valuation is the continuation of rapid growth and stout margins for many future years. This is attainable, in my mind, given Apple has already demonstrated the capability to create new products and attract customers. Amazon’s market value hinges in the expectation that margins will expand. Amazon has yet to prove that it can boost margins consistently for years now. Until Amazon exhibits consistent improvement in its margins, I will use historical op margins of 4% in my valuation assumptions. Without rising profit margins of at least 6%, AMZN is overvalued.

Relative Valuation- Price/Earnings Multiple
APPLE:
Apple ($185) currently trades around 37x 2008 consensus EPS estimate of $4.97. On the surface, it’s a pretty rich multiple, yet in reality, Apple’s multiple is lower when taking account of a couple issues.

First, Apple always provides very conservative guidance. This is no secret; Wall Street adjusts its earnings estimates in response to management’s low-balling, yet Apple still manages to mightily exceed the consensus earnings number. Hence, history suggests that one should assume that future estimates are too low. AAPL has averaged 32% earnings surprise for the last four quarters, and for the last 2 years, earnings came in approximately 25% higher than estimates on average. Those figures don’t account for the revisions during the months leading up to an earnings announcement. In the past 2 months, Apple’s 2008 full year estimated earnings were revised upward about 13%, and we still have almost a whole year until 2008 earnings are released. Actual 2008 earnings might possibly be 10-30% higher than the current consensus estimate.

Second, EPS is an accounting measure based on accruals, not actual cash received by the firm. Apple’s special accounting treatment for its iPhone spreads revenues over a 24 month period even Apple receives cash for the device sale up-front. Thus, the cash pouring into Apple pockets is recorded as deferred revenue on the balance sheet. When taking into account “cash earnings” opposed to accounting earnings, EPS would be somewhat higher, depending on the level of iPhone sales / deferred revenue accruals.

In sum, investors pay a multiple based on their earnings expectations, not necessarily on the publicized consensus estimate- a whisper pro-forma estimate that adjusts for accounting issues and conservative guidance, Hence, for relative purposes, there’s a strong case for saying AAPL trades at lower P/E, possibly in the low 30’s.

Apple’s growth has been extraordinary the past couple of years. Assuming that this will continue, a 30ish price multiple is likely justified. On average, analyst project 23% earnings growth annually for the next 5 years which produces a PEG ratio less than 1.5 (using a 33 multiple). Apple’s earnings have grown 150% the past 5 years according to Yahoo (YHOO).

AMAZON:
Amazon ($90) trades 56x its $1.61 FY08 estimate. Historically, AMZN's reported EPS has been in a close range of the Street’s estimates, except for a couple of blow-out quarters. Thus, no clear, consistent earnings pattern exists to assume that estimates are too high/low. Amazon’s sales figures have been fairly consistent, but its profit margins are volatile. Amazon’s multiple 56x multiple is likely realistic.

The 5 year projected growth rate for AMZN is about 23% making the PEG greater than 2. That’s expensive, but if you believe that margins will expand significantly then growth will be much greater and consequently AMZN shares less overvalued.

Discounted Cash Flow Valuation: FCFF
APPLE:
According to my DCF model, the fair value of AAPL shares is $175 versus recent market price of $185. The input assumptions are fairly aggressive: expectations for sales growth and operating margins to maintain their strong momentum for many years going forward. The model uses 22% annual revenue growth for next 5 years, and for years 6-12 annual growth transitions from 15% to 5%.

Sustaining high annual growth rates becomes increasingly difficult due to the law of large numbers. Revenues only have to increase by about $5 billion to equate to 22% growth rate next year, yet in year five, a $11 billion annual sales increase is required to attain 22% growth. Apple will need to attract new customers in larger and larger increments to generate the level of expected sales implied by the share price.

Key Point: To justify Apple’s current share price, margins and sales growth must remain strong for a considerable period of time. Apple has significant momentum in its favor: massive brand power, innovative product design, and a strong portfolio that leverages individual products to boost demand of other products (“Halo Effect”). Apple products receive very high customer satisfaction, almost seeming every new user of Apple products end up loving them. However, there is a possibility that much of the low hanging fruit has been picked, and attracting new customers will be more difficult if they are not pre-disposed to adopting Apple’s products.

Conclusion: I am more confident than not that Apple will/can match these expectations. Yet, I am not completely confident Apple will meet or exceed the price-implied growth/profitability expectations. In my opinion, expectations are neither too high/low to assert comfortably that shares are over/under-valued. In essence, AAPL is fully-valued and to assume otherwise would entail prophetic guessing, in my opinion.

AMAZON:
Amazon’s intrinsic share value is $60 based on the DCF model compared to $90 market price. 5-year expected annual sales growth is 24%, then transitions (7yr) from 21% to 5.5% starting in year 6. Input assumptions for operating margins hold steady @ 4% during the 12-year horizon. I believe achieving high sales growth levels will not be a problem for AMZN. Amazon margins are the primary factor behind the discrepancy between market and model values.

Key Point: Amazon shares are priced on expectations for margin expansion in future years. Amazon’s operating margins have shown significant volatility in past periods, and the firm has yet to demonstrate it can attain above 4% consistently.

Amazon must offer discounted prices to generate revenue. Since many retailers sell the same products, competition is based on price. Competitors with the lowest cost structures can offer the lowest prices, thus business strategy revolves around attaining economies scale and cost efficiencies. Amazon sales have increased 100-fold in ten years but the operating leverage and cost advantages have not been so robust, as one would naturally expect.

In order to avoid price competition, Amazon must differentiate its offering. Amazon has been working to accomplish this, yet the increases in R&D spending shaves margins. The hope is that the high R&D expenditures will materialize in fatter profit margins as AMZN diversifies its revenue streams.

Conclusion: We have yet to observe solid evidence than Amazon will be able to boost margins above levels for the average retailer. Investors have been expecting that to happen, and management says that it will, but until then I am skeptical.
Summary:
Both firms have lofty expectations to live up to, but Apple has the hot hand as of now. That’s not a secret, hence the reason AAPL is trading at a high multiple. Amazon is very rich at its current share price, but historically investors have been patient, and I don’t foresee a major drop in the share price in the near-term. If higher profitability doesn’t eventually come to fruition at Amazon, shares will definitely come under pressure.
I don’t expect stock returns to be above normal for both Amazon and Apple in the coming quarters due to all the good news and the high expectations currently reflected in their share prices. But, both are terrific companies and If I owned them I wouldn’t want to sell them. In the long-run both should do well.
Disclosure: I do not have a position in any of the stocks mentioned.

Comments

[Tom B]

I think your analysis is dead on. I've always considered AMZN too "rich" to buy.

"However, there is a possibility that much of the low hanging fruit has been picked, and attracting new customers will be more difficult if they are not pre-disposed to adopting Apple’s products."

It's an interesting problem. I think the iPhone is very early in its product life cycle and will be a growth driver. I think Apple COULD capitalize on products like AppleTV when that product reaches a threshold level of maturity AND TV starts moving increasingly to internet delivery.

But, Apple's core product is the Mac. I think they can hit 20% domestic market share within 4 years (from 8% now). Moreover--- this is controversial-- I think Enterprise will someday work out how much money they blow on Windows support annually and become shocked and appalled by the number. I think UNIX-based OS's, like Apple's are too good for "creatives" and "professionals&qu... only-- OS X has much to offer the average worker, with regards to security, multitasking performance, and intuitiveness.

[Lillama]

I really appreciate the analysis you have done here. I would like to see more articles of this kind. I have been holding both of these stocks for many years, and recently, I have been really unsure about whether to sell some shares, but it is hard to decide since I lack the knowledge to analyze them as you have done. I hear so much commentary on them both being overvalued, but no one in the media has been specific enough, until now. Thank you so much.

[redwood]

I think amazon is only going to grow.I don,t think you are right on this call.Amazon is branching out in to new things it won,t just be know as the worlds biggest on line retailer to which that by its self is no small feat.Amazon over the years was more into building a humongous customer base which they have done and now they are just starting to looking at making a profit.I have a lot of faith in this company if you are in this for the long haul you are going to make out very well or if your not you get what you put into it !

[T Muller]

Redwood,
I am not questioning Amazon's ability to grow, I think they can grow significantly. The issue is the profit margins. Retailers have low profit margins, and the stock is priced with expected profit margins to be much higher in future years. Amazon has yet to prove it can boost margins above the retail industry range. The few qtrs AMZN posted high margins, its R&D spending was low and tax rate very low too. (not normal operating conditions)

I think Amazon is gong to do very well. Especially in the long-term. Yet getting in at the current stock price will likely result in below average returns. To earn superior returns, an investor needs to buy stocks at prices that reflect expectations that are likely beatable, not stocks with price implied expectations that are likely difficult to meet.

I agree with your comments, but the issue at hand is valuation at current share price. If Amazon shares were much cheaper it would be a no-brainer.

If one bought AMZN a while back, perhaps when it was attractively valued, he/she shouldn't sell now just because it's overvalued. Investor returns are determined by the price paid, thus buying at these levels is not favorable, but holding is because overtime AMZN will do well. The stock has made it's run for the time being, so I expect near-term returns to be below average.