Amazon's (AMZN) valuation has been all the rage lately. Investors either seem to agree that the company will continue to post astronomical growth, or they become pessimistic and believe that the stock will soon fall from the stratosphere back to earth. My aim is to provide some insight into some of the drivers of Amazon's share price.
As of now, Amazon's share price is astronomically high. The company is trading at 90 times projected earnings. For comparison sake, Apple (AAPL) is trading at 10.5 times projected earnings and Google (GOOG) is at 12 times projected earnings. At the writing of this article, Amazon is trading around the $228 mark, with a 52-week high of $167 and a low of $247. While I do consider Amazon to be grossly overvalued, the company has positioned itself for strong growth and financial stability, and the stock could experience even higher highs before a significant fall. Here's why.
Economic and Population Growth
Martin Holdrich, Senior Economist of Washington, DC-based Woods & Poole Economics, one of the nation's best economic forecasting firms, believes that the United States will begin an upward trajectory of slow, continued growth. Mr. Holdrich explains that cyclical industries, such as manufacturing and consumer sales, will pick up, especially in 2013, as the economy recovers and as the United States continues to add to its growing population.
This news bodes well for Amazon for two reasons: First, Amazon faces less risk that one of its manufacturers or suppliers will go out of business. More importantly, however, an economic recovery and an increase in population translate into sales increases for the retailing giant, which will provide goods to the country's growing population.
Amazon has posted sales growth of 40%+ over the past two years. While most companies can only keep this type of growth going through an aggressive acquisition strategy, Amazon is capable of mixing a conservative acquisition strategy with strong organic growth. If Mr. Holdrich is proved correct, then America may demand Amazon's products and services even more as the country's population and economy continue to expand.
Margins Under Fire
Amazon sunk an enormous amount of money into bringing the new Kindle Fire to market. At $199, the Fire, which sells for less than half of Apple's least expensive iPad, originally took the market by storm, scooping up 17% of the market. Since that time, however, Amazon's share has dipped to a miniscule 4%.
While the market share boost was positive for the company, it is estimated that Amazon loses $10 per Kindle Fire, making the product akin to printers and ink, where companies would all but give away the printers in hopes of turning a profit on the ink. Amazon is pushing its users into buying its higher-margin Kindle books, and it is encouraging consumers to share books with each other in hopes of making the service more "sticky." In the short run, this will hurt Amazon's margins, but if it succeeds in gaining users, then its margins will certainly improve.
That said, Amazon's profit margin has taken a terrible nosedive. The firm's margins have been steady until 2011, when they dropped off. For profit margin, Amazon posted 3.7%, 3.4%, and 1.3% during each of the last three years. For comparison, major retailer Wal-Mart (WMT) saw margins of 3.5%, 3.9%, and 3.5%.
Amazon should see this as a major weakness, because the company has a competitive advantage in that it does not charge sales tax for most everything it sells. The firm does pay shipping costs, however, which were exacerbated from new users subscribing to Amazon Prime, where users get unlimited two-day shipping. New Amazon Prime users contributed to Amazon's decrease in profit margin, as the company lost nearly three times more for shipping costs than it took in for shipping revenue.
Even though Amazon's new kindle has been a drag on its results, the company has a long-term perspective. Amazon is positioning itself well to compete with in the E-Reader space. Amazon hopes to be able to capture a larger share of the book market with its new device. It is worth noting that Google competes in this space with its Google Books product, which is free, but for the serious reader, Google's service is not a convenient option.
Amazon is also jumping into the video market. In 2010 the company purchased Lovefilm, giving it exposure to the European media market. Lovefilm is the leading provider of DVD rentals and streaming in the UK and across Europe, and Amazon purchased Lovefilm because of its strategic position.
This acquisition-along with Amazon's initiative to continue to dip into the streaming market-poses problems for Netflix (NFLX), which earns a sizable chunk of its revenues from streaming. The media content market is huge, so look for Amazon's share price to jump if the company makes strong headway here.
Any significant progress in these new areas should certainly be a positive driver for Amazon's stock price.
Valuation Moving Forward
As aforementioned, I feel that Amazon is very much overpriced at this point in time. While I don't mind if a company is trading at a high price to earnings ratio if its earnings are growing faster than its stock price (as was the case with Apple one year ago), I am wary of buying a company has such a high price to projected earnings ratio. Amazon's is 90, and its price to earnings ratio for the trailing 12 months is nearly 189. If Amazon's price were to drop due to bad news, a pullback, or especially a combination of the two, I may be interested in the stock, but probably not.
At this point in time, however, I see the company as more of a risk play. Amazon's stock could experience swift gains to the upside, known as a climax top, but I am very wary of putting capital into an overvalued-albeit fast-growing-company.