Bill Mauer penned an article stating that Amazon (AMZN) could have tremendous upside based on its Price to Sales ratio and posed the question: "Now, do you think that price to sales value is too high, or too low?"
Price to Sales can be a useful metric when earnings are currently depressed, and can be expected to expand at some point in the future. This is the bull case for Amazon which says they are sacrificing margins now for future growth and future profitability. By dividing the Price to Sales ratio by the Earnings to Sales (or net income margin), you calculate a P/E: P/S divided by E/S = P/E. (Note: I prefer using Enterprise Value to Sales which includes net debt in the calculation as it adjusts for capital structure differences.)
With a TTM P/S for Amazon of 2.14x currently and a net income margin of about 0.7%, you can calculate its current P/E of 305x. If you expect that net income margins in the future will expand back to their high from 2009 of 3.7%, you get an expected P/E of 58x. The ratio of Price to Sales you should be willing to pay for a company is directly related to the net income margin a company can generate on those sales.
Maurer compared the Price to Sales ratios of Amazon of 2.1x with those of tech companies Apple (AAPL - 4.4x) and Google (GOOG - 5.5x) as well as retailers Wal-Mart (WMT - 0.54x) and Best Buy (BBY - 0.12x). With peak net income margins of only 3.7%, Amazon is not, and never will be, comparable to Apple and Google, which were able to generate TTM net income margins of 26% and 27% respectively.
If Amazon is ultimately successful in delivering an increase in profitability, its business economics are much more likely to be closer to the world's retail leader Wal-Mart, which had TTM revenues of $460 billion and net income margins of 3.7%. Using Wal-Mart's P/S ratio of 0.54, Amazon would only be valued at $64 per share. But, as Maurer later pointed out, Amazon's sales are growing 6 times faster than Wal-Mart, so it should deserve a higher multiple. Assuming that Amazon's sales can eventually be as profitable as Wal-Mart's (a very big assumption to make), that is true. So the question becomes, what type of sales growth expectations does Amazon have relative to Wal-Mart at its current valuation?
If Wal-Mart can grow revenues at 5% and Amazon can continue to grow revenues at 25%, how many years would it take so that the valuations were equal? The answer is 8 years and the math is as follows:
- Wal-Mart: TTM sales of $460 billion x 1.05^8 = $680 billion, current equity capitalization of $252 billion for a Price to 8 years forward Sales of 0.37.
- Amazon: TTM sales of $54 billion x 1.25^8 = $320 billion, current equity capitalization of $119 billion for a Price to 8 years forward Sales of 0.37.
At the current price of $258, relative to where Wal-Mart is currently trading, you are betting that Amazon will be able to generate about $265 billion additional revenue annually than they did in the last 12 months of $54 billion (and more than the $237 billion in total revenue generated in all of their 17-year history). This would be with Wal-Mart increasing annual revenues by about $220 billion and again, assumes that Amazon's net income margins would match Wal-Mart's.
Even with Wal-Mart's low growth rate of 5%, total revenues will increase by $25 billion this year, which is about 80% more growth in dollars compared to Amazon's expected $14 billion revenue increase. If Amazon were to continue to grow at 25% per year and Wal-Mart at 5% per year, in year 8 Amazon would have to add $64 billion of annual revenue versus only $32 billion for Wal-Mart. That seems to be an extremely high hurdle to accomplish, but what is required to justify the current valuation.
How has Amazon been able to grow revenues over the last 4.5 years from $14.8 billion in 2007 to $54.3 billion in the last 12 months, a rate of 33% per annum? Even though it has enjoyed a significant built in cost advantage by not charging sales tax, it has generated no incremental profit on the nearly $40 billion of incremental revenues, with 2007 profits of $476 million and last 12 months profits of $377 million. Had their margins been stable over this time period, expenses would have had to have been approximately $2 billion less per year. In 2011, they subsidized shipping costs to the tune of $2.4 billion.
Take away the sales tax advantage and the subsidized shipping costs which are necessary to increase their margins back to the 3.2% level of 2007 (and still below the 3.7% of Wal-Mart), and your cost advantage disappears along with your sales growth. It is highly unlikely that Amazon will be able to simultaneously achieve both the optimistic revenue growth and margin expansion necessary to justify the current Price to Sales valuation relative to Wal-Mart. Getting back to the original question of whether the Price to Sales ratio is too high or too low, the overwhelming probability is that it is currently too high.