Amazon's (AMZN) high PE ratio has made some investors nervous about the company's valuation. Using an economic profit model with adjustments made to better reflect the economic substance of Amazon's investment spending, it will be shown that Amazon's market value relative to its current profitability is not egregious. Even if a stock is not overvalued, it can perform poorly in subsequent periods; for example, investment plans can go awry, producing poor returns or profitability of existing business lines can suffer due to changes in the market. In Amazon's case, there is plenty of room for failure, but subsequent stock performance will not be solely influenced by today's PE.
The basic economic profit formula is: FV = (R - d) * NCI / d + NCI, where: FV = Firm value; NCI = Net capital invested; R = Rate of return; and D = discount rate. In the implementation of the model used to value Amazon for the purposes of this article, the rate of return is calculated using an internal rate of return (IRR). The inputs to the IRR are gross capital invested, gross cash flow and asset life.
The key to implementing the model in a way which yields sensible results is the process of adjusting the company's financial statements to better reflect economic realities. One major adjustment in Amazon's case is the capitalization of technology and content, and marketing expenses. These are really assets in that they produce benefits over a time frame greater than one year and therefore should be capitalized.
Turning to Amazon's financial model, in summary the company has gross capital invested of about $16.5 billion, including major items such as $6 billion of tangible property, $7.8 billion of capitalized technology and content spending, $3.1 billion of capitalized marketing spending and a negative $4 billion of working capital. Gross income at Amazon, based on analyst estimates for 2012 EBITDA and the impact of capitalized expense add-backs is $7.5 billion. This includes adding back TTM technology and content expenses of $3.3 billion and marketing expenses of $1.8 billion. Asset life is calculated at a little under five years, based in part on an asset life of six years for technology and content, three years for marketing and four years for tangible assets.
Running the IRR calculation leads to a real (inflation-adjusted) rate of return of about 32% and a modified IRR of 30%, reflecting a normalized reinvestment rate. Comparing this to a real cost of capital of 4.9% leads to justified valuation for the existing business of about $159 per share, or a little over six times the amount of economic capital (NCI) invested. Extending the analysis to account for growth shows that in order to justify the current per share trading value of $212, the company would need to grow about 4%, in real terms, for the next decade. Above and beyond this level of growth, the company will also need to grow cash flow in order to sustain returns on capital due to its investment program.
Taking a step back, it is worth considering what is driving value; Amazon generates a considerable amount of gross cash flow: as shown above about, $7.5 billion. Looking at firm value (FV) of $94 billion and comparing to gross cash flow, we can see a multiple of about 12.5x. This is a similar metric to FV to EBIDA for old economy firms that have the ability to capitalize most of their investment.
The capitalization of technology and content, and marketing does not give Amazon a free pass, rather it shifts focus to the effectiveness of the company's investments. In 2011, Amazon invested $2.9 billion in technology and content and $1.6 billion in marketing compared to $1.2 billion and $680 million, respectively in 2009. The question is whether Amazon will grow cash flow enough to justify this extra investment. If it does, the company has a good chance of justifying its current valuation, if it falters, then the stock will prove a worrisome investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.