Show Me The Money
After a decade of remarkable growth, Amazon (NASDAQ:AMZN) continues to generate enormous revenue increases. Nonetheless, the company has failed to generate significant profits. In consideration of this, investors must step back and question the value of a company which is not profitable as an entity.
While a private equity firm may look at Amazon's individual components and note significant profit streams which are used to fund other unprofitable segments, such a firm could create value by splitting up the company and shedding the loss-generating entities. This article does not argue that Amazon is worthless just because it doesn't earn profits, rather, the company cannot be valued on the basis of revenue growth alone.
Persistence Of Bubbles
Throughout the history of finance, across all asset classes, bubbles have inflated and subsequently collapsed. The type of bubble which I would like to focus on is not the systemic bubble in which entities in an asset class are overvalued (like homes in 2006), but rather a bubble within a single asset (like tulip bulbs in the 17th century). Economists consider a bubble to be the scenario in which an asset is priced at a premium to its economic intrinsic value. This overvaluation is often driven by speculation.
Speculation is the purchase an asset with the intent of selling it at a higher price, where the price increase is unsubstantiated by a fundamental improvement in the asset. An example of such would be the purchase of a Inverted Jenny postage stamp or a Picasso painting. Investing, on the other hand, is the purchase of an asset with the intent of reaping economic rewards from the intrinsic value of the asset.
The Value Of Stock
Shares in a company are a claim on residual equity once all senior claimants are repaid. This means that a shareholder owns the rights to a company's profit once suppliers, employees, lenders and everyone else is paid. When one buys a stock, that person is buying the rights to all future profits of the company, whether generated through operations or through asset liquidation. This means that a company which is expected never to profit should only be worth the value of its net assets.
However, projecting profitability of a company is rarely an exact science. The largest driver of company profitability is the overall macroeconomic condition of its consumer. Some companies are more sensitive than others to changes in macroeconomic conditions, and for this reason they are discounted in value. Analysts attempt to price in risk by use of empirical measures such as beta.
The Value Of Amazon
No rational value investor could stomach a purchase of Amazon's shares. Why is that? It's virtually impossible to assign a value to Amazon and, therefore, there's no way to confidently assess that you're buying those shares at a bargain. However, it's quite simple to assert that by many metrics the shares are grossly overvalued, the primary method being profitability.
Looking at the past decade, Amazon has been marginally profitable in eight of the past ten years. While in that time period Amazon has grown its revenue ten-fold, its share price has risen over thirteen-fold. While in terms of annual growth rates, the growth is similar, for the price to be justified today investors must be pricing in the same growth during the next decade as they have during the past decade.
But for argument's sake, let's say that Amazon will keep growing revenues at this pace - not an unreasonable assumption considering that e-commerce retail sales account for only 9% of total retail sales.
Amazon still does not have the profits to attain a $280 billion market cap. Were we to value Alibaba (NYSE:BABA) at the current Amazon valuation based on earnings (applying Amazon's P/E to Alibaba), the company would be worth $4.8 trillion. Now let's add a China discount. Chinese large-cap companies trade for about eight times earnings (NYSEARCA:FXI) as compared to 17 times earnings for American large-caps (NYSEARCA:SPY). That's a tremendous discount considering the disparity in American growth vs. Chinese growth. However, the disparity takes Chinese currency weakness into account as well. Alibaba would still be worth well over $2 trillion. It sounds ridiculous only because it is ridiculous.
Don't Short This
So why am I not short Amazon? I believe that Amazon was overvalued ten years ago, and I won't short it now for the same reason I didn't short it then. Bubbles can persist indefinitely, and if you're short, you could get steamrolled. Who is short Amazon? Pretty much all of Wall Street is. How can I claim that when only 1.5% of shares are shorted? According to the S&P, institutional owners hold over 80% of the shares in S&P 500 companies, but for Amazon that number is 67%. A fund manager who is benchmarked against the index but doesn't hold Amazon's shares is essentially short Amazon. However, while in most cases I wouldn't sell shares in a good company after a surge as not to create capital gains, I would if I were holding Amazon. Who knows when the music will stop.
Disclosure: I am/we are long BABA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.