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Are We All Being Fooled By Amazon?

|About:, Inc. (AMZN)

In this article I show how I calculated the intrinsic equity value of Amazon, $121.98 per share.

Then I attempt to explain such an extreme difference with the current stock price.

And finally I outline two possible scenarios for the future stock price movement.


My equity value computation

In order to find intrinsic equity value of Amazon (NASDAQ:AMZN), I used discounted cash flow (NYSE:DCF) valuation approach projecting free cash flows to the firm for the next 10 years.


Revenues: three-stage growth model. High growth at 20% for the next 4 years, transition period from 18% in 2020 to 6% in 2026, and stable indefinite growth rate at 5.7% calculated from KMacK multiple-to-additive regression.

Operating Income: 1.1%, average of the previous three years.

Tax Rate: 46.2%, average of 2013 and 2015, though it fluctuates terribly from year to year.

Depreciation & Amortization % of Revenue: 4.8%.

Capital Expenditures % of Revenue: 5%, assuming Amazon invests more than the depreciation expense on existing assets is.

Change in Working Capital % of Revenue: 0.6%, average of the previous three years.

I also included acquisitions expense as a cash outflow because Amazon has been acquiring a lot of companies over the past years: 695.3M.

I did not add back stock-based compensation since in effect it has cash value.

WACC: 10.4% (source: Bloomberg Terminal).

Note that I did not subtract capital leases from the implied enterprise value which would lead to even lower equity value.

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The model resulted in $121.98 implied share price, a discount of 374.7% to current $579.04 on March 1st, 2016. Now, the last time Amazon's stock was below $121.94 was in July 2010. In order to eliminate a chance of some fundamental mistakes in my model, I compared my result with the one which Aswath Damodaran came to in 2014. His result, $175.21 compared to $287.06 at that time, also shows that the company is severely overvalued.

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For the lack of any other known to me technical valuation method (public comparables method will not give accurate result, in my opinion, since there is no such closely comparable to Amazon companies), I considered going back to basics of economics and finance theory in order to explain such a drastic difference between the intrinsic and the current market value of Amazon.

Back to basics

Why do firms exist according to the microeconomics theory? Because they provide outputs for the eventual consumption by the end-users. How do they do it? They turn inputs into outputs by coordinating a set of available resources with a given technology. In the long run, all inputs are variable, and a firm must find a way to efficiently increase output. It can do so via:

  • Economies of scale (a doubling of output requires less than a doubling of cost)
  • Technological change (same output can be produced with smaller amounts of inputs)

Jeff Bezos chooses to focus on scale:

We will balance our focus on growth with emphasis on long-term profitability and capital management. At this stage, we choose to prioritize growth because we believe that scale is central to achieving the potential of our business model.

Due to the lack of data on the actual number of output and the service-oriented nature of business, I will refer to revenue as an indicator of output growth.

The scale has obviously expanded, however, net income stayed the same which means that costs increase proportionally with output, thus there are neither economies of scale nor diseconomies of scale. The operating efficiency of Amazon has not been improving.

Now let's recall what financial theory tells us. The objective of a firm is to maximize the shareholders' wealth, i.e., the value of their stake in the firm. For a public company, an indication of wealth can be easily indicated in a stock price. And if investors are rational, stock price will reflect management's both short-term and long-term decisions on an appropriate choice of projects that should generate a return on investment at a given risk level.

Let's look what Jeff Bezos understands by shareholder value:

It's All About the Long Term

We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.

Note that it's hypothesized that market leadership will lead to an increase in shareholders' value.

(Source: Ycharts)

In fact, net income has not been increasing since the foundation of the company.

One might argue that since it's based on accrual accounting rules, net income is not an objective representation of real profitability. Let's then turn our attention to the net change of the cash flows which In effect gives an idea of the company's uses and sources of cash.

(Source: Ycharts)

Net change in cash flow has been slightly above zero over the past five years. The Amazon's exorbitant share price growth is not commensurate to its earnings and net cash inflows growth.

Moreover, from the basic accounting theory we know that some companies make profits by charging higher prices, others by controlling costs. There is no other way around it. Amazon does neither.


It looks to me quite suspicious that a management of the company with such great business profile would intentionally choose not to be profitable for over two decades. Why not re-classify itself into not-for-profit organization? Well, then there will be no opportunity to gain from the price increase of a publicly traded stock. Keep in mind that 18% of Amazon is owned by its CEO and he is the 4th richest person in the world.

Jeff Bezos stated that he cares about long-term value. Well, 20 years have passed, isn't it long enough? One might argue that shareholders are expecting to see an increase in firm's value from the hypothetical future cash flows generated by the numerous Amazon's projects. Then the question is, how long are the shareholders willing to wait?

Right now it looks to me that the only reasonable explanation for a share price growth is the investors' speculative behavior. Since Amazon does not pay out dividends and there are no earnings foreseen in the future, the only way that the shareholders can increase their wealth is by getting a capital gain from a sale of the stock. It is in their best interests to keep artificially pushing the price up.

One thing I can tell you for sure, Bezos is a truly ingenious founder and executive manager in convincing shareholders to put their faith in the mystical long-term value and close their eyes on real business performance.

Nobody knows his exact plan. Perhaps you should keep an eye on insider trading activity.

Like the one on August 5th, 2015 when the CEO sold more than $500 Million in Amazon shares after the stock price climbed to its top.

(Source: Google.Finance)

(Source: Edgar)

I conclude

If investors continue to expect an perpetual increase in Amazon's share price thus driving the current price up, then my DCF computation is useless here and no conventional financial theory can explain how on Earth a company's stock with earnings hovering at zero for 20 years has increased by 31,883.79%.

If, on the other hand, the investors will decide to go back to fundamentals, especially during a market downturn, a tiny trigger will spark panic leading to a burst in the bubble and a share price correction to its intrinsic value.

With such high level of uncertainty, I recommend to long AMZN and hedge against the loss in case of stock plummet.

(References: "Financial Accounting" by Hoskin, Fizzel, Cherry; "Microeconomics" by Pindyck, Rubinfeld; "Corporate Finance" by Brealey, Myers, Allen; blog posts by Aswath Damodaran)

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

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.