The market, Wall Street analysts and my fellow Fools were tripping over themselves on Friday to gush over Amazon.com (NAS: AMZN) after the company released earnings. A $0.28-per-share profit was quadruple what analysts had expected, and of course shares surged as a result.
After the 15% bump in share price on Friday, the stock trades at 170 times trailing earnings, an absolutely insane valuation in my eyes. Just how insane is it? I've put some numbers together to highlight just how much growth and profitability are already priced into the stock.
The infinite growth curve
Let's work backward into the valuation the market is already putting on the stock. I like to be able to see how a company can reach a P/E ratio of 10 sometime in the near future as a starting point. This is about the same P/E as Intel, Apple (NAS: AAPL) , and Microsoft (NAS: MSFT) when you take out their cash hoards, so it's also a reasonable valuation to use. If Amazon is going to reach a P/E of 10, the company will have to make $10.3 billion in profits. How could it get there?
I outlined three revenue levels Amazon would have to achieve to reach $10.3 billion in earnings with net margins of 2%, 4%, or 6%. The highest margin Amazon has ever recorded was 3.7% in 2009, and in recent history. margins have hovered around 3.5%, so the table gives us a pretty reasonable range to look at.
In these cases, Amazon would have to reach revenue of $172 billion to $515 billion from a current revenue level of $51.4 million in the past 12 months. Since the argument nearly everyone is making is that Amazon is forgoing near-term profits for growth and long-term profits, the assumption would be that eventually the company will grow enough to live up to its current valuation. But if Amazon is ever to grow into its valuation, it's going to have to keep growing at an astronomical rate. Following are the annual growth rates Amazon would have to maintain to reach to revenue level above in five, 10, or 15 years.
5-Year Growth Rate
10-Year Growth Rate
15-Year Growth Rate
If we assume, optimistically, that Amazon can reach a long-term net margin of 4%, it would grow into its current valuation in five years if it grew revenue at 38.1% a year, a level that's almost unheard of for a company this size (outside of Apple). It would reach that level in 10 years if it grows at 17.5% a year.
Remember that this is only to grow into its current valuation and doesn't assume any increase in the stock price or the number of shares outstanding over this time frame. Usually, investors would discount the stock price by an expected rate of return as well, meaning the actual growth the company will need to achieve to keep up with the market is higher than this.
Always low prices, and margins
Theoretically, Amazon could grow fast enough to grow into its valuation, especially if margins expand. The problem I have with the overall investment theory in Amazon is that the business doesn't operate in a fundamentally high-margin business. The opposite is true; it's in a low-margin business where competition will always be fierce.
Online retail is only worthwhile because it's cheaper than brick-and-mortar competitors. If Barnes & Noble (NYS: BKS) offered the same selection at the same price as Amazon, I would shop there. The competition is also willing to cut prices to stay in the game. Overstock.com has a profit margin of -1.6% because it is trying to compete on cost, so Amazon has to keep up with these costs.
The streaming business Amazon is trying to get into will also have limitations when it comes to profitability. As Netflix (NAS: NFLX) found out, content providers are demanding more and more for their content, and there is little barrier to creating their own distribution channels if they want to.
Then there's the Kindle business, which is attempting to enter into Apple's territory -- except Amazon has had to sell Kindles at a loss to enter the market and new devices are emerging using Google and Microsoft's operating systems. Today's announcement that Microsoft will invest in the Nook brings in more competition, making this an even tougher business for Amazon to capture.
I'm not seeing anything but low-margin businesses in Amazon's future. That's OK if the company can grow quickly, but if the record stops, so does the stock.
Betting on perfection
The bottom line is, Amazon will have to perform nearly flawlessly to live up to its current valuation. When stocks are priced for perfection, that's when disaster happens, and that's what I fear could be in Amazon's future. The list of companies that didn't live up to outrageous valuations is long, most recently including Netflix -- something I warned about as the stock peaked.
At the time thisarticle was published Fool contributorTravis Hoiummanages an account that owns shares of Apple, Microsoft, and Intel. You can follow Travis on Twitter at@FlushDrawFool, check out hispersonal stock holdings, or follow his CAPS picks atTMFFlushDraw.The Motley Fool owns shares of Microsoft, Amazon.com, Intel, and Apple.Motley Fool newsletter serviceshave recommended buying shares of Microsoft, Apple, Netflix, Amazon.com, and Intel, creating bull call spread positions in Microsoft and Apple, and writing puts on Barnes & Noble. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
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