Apple Vs. Amazon: The Valuation Dilemma

Includes: AAPL, AMZN
by: Carlos X. Alexandre

This is a great time to bring these two companies under the financial microscope, especially with the introduction of the Kindle Fire, Amazon's (AMZN) tablet. On the technology front and based on what I’ve read thus far, the Fire and the iPad are two devices with similarities, yet different enough to appeal to different market segments. There’s an overlap in there somewhere, but the major differences are price and features. The Fire is cheap, but has fewer capabilities, and the iPad is expensive by comparison, but has a larger screen, two cameras, supports 3G mobile broadband, has more storage, and longer battery life, among other goodies.

As an example and as an informal market analysis, my wife is price conscious, doesn't see a need for a camera, and refuses to pay a monthly fee for mobile broadband, yet a regular computer is overkill. My daughter is in love with the iPad, all the gadgets associated with it, and likes to have a ton of devices at her disposal. I need the computing power of my laptop, can tell the difference between a bit, a nibble and a byte, can still do binary math in my head, refuse to carry two devices, and do not want to be connected 24x7.

But this article is not about technology and having spent over a decade in the information technology field, and having dealt with extremely bright inventors that worked for well known companies – Toyota (NYSE:TM), Xerox (NYSE:XRX), Infineon (OTCQX:IFNNF), and Rolls Royce Aerospace, among others – believe me when I say that I understand technology. But my passion lies in the investment world, and I always try to decipher what drives investors to make certain decisions, although success is not always the end result.

Thus, Apple (AAPL) and Amazon are two public companies that deliver the goods for this exercise, and the typical valuation argument centers on growth rates, price-to-earnings ratios, and so forth. Often we hear someone say that a given company is cheap because its price is only 10 times next year’s earnings, or something along those lines. Who determines that a P/E of 10, or any number for that matter, is the “undervalued” or “overvalued” measure?

Next I present a table that shows the year-over-year earnings and revenue growth rates for Apple and Amazon for the last three fiscal years, and Apple’s fiscal year ends in September while Amazon’s ends in December.

2008 2009 2010
Apple Revenue Growth 35% 32% 52%
Amazon Revenue Growth 29% 28% 40%
Apple Earnings Growth 36% 68% 67%
Amazon Earnings Growth 32% 37% 24%

As one can see, Apple’s growth over the last three years was superior across the board, and the earnings growth in 2009 and 2010 were not even close. Yet, Amazon has always commanded a higher P/E, defying all logic.

Certainly one can look at all financial ratios when seeking an answer as to why these companies present investors with such valuation discrepancies, but the price-to-earnings ratio is the bread and butter of the investment world. Cash flow and a number of other measures yields no clue in this case, and only the Price/Sales ratio stands out. Based on this ratio, Amazon is cheaper. But notice how Apple’s P/E contracted while Amazon’s expanded over three years for no apparent good reason.

Apple Amazon
Price/Sales Ratio 3.67 2.59
Price/Book Value 5.31 13.43
Price/Cash Flow Ratio 14.60 58.10

Maybe it’s because they are in different industries. Well, Apple is listed as being in the “Personal Computer” industry while Amazon is categorized as a “Catalog & Mail Order House,” and the personal computer industry has a current average P/E of 15.3 while the catalog business has an average P/E of 69.3 -- and potentially Amazon’s own P/E is distorting the average. And that is the best clue that I was able to uncover, although there’s still no explanation as to why there’s such a difference in valuation.

Furthermore, Apple and Amazon have been converging into the same markets, and the three products that they have in common are technology, content, and cloud services. Probably in five years one won’t be able to tell them apart.

But I will go back to the valuation question, seeking a good explanation as to why these two companies are worlds apart, as far as the common ratios and valuation methods are concerned. And the answer is that the “Inefficient Market” is not a theory, but a reality, and investors as a group have an amusing way of placing their bets.

Based on the data, is Apple worth $2,500 based on Amazon’s P/E, or is Amazon worth $35 based on Apple’s P/E? Most ratios are great tools when evaluating the purchase of a local business. For example, a friend of mine bought a restaurant in Washington D.C., with a Price/Sales ratio of 0.25 and Price/Cash Flow of 1, and still feels that he could have done better. But when it comes to the world of stocks their usefulness is very far from perfection.

Thus the thinking may be that based on historical ratio data a stock is likely to stick to a range, and I can understand that for lack of a better measurement, but when market sentiment changes, whatever the reason, no ratio holds up to scrutiny and only capital flows determine the new normal.

To set a future price level based on any financial ratio is as reliable as me rubbing maple syrup on my bald spot and expecting hair to grow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.