“I am a better investor because I am a businessman, and I am a better businessman because I am an investor.” In addition to the charming chiasmus of this sentence, I greatly enjoy this Warren Buffett quote for the substance of the statement as well. It is a useful sentence to keep in mind when evaluating the investment merits of a stock that has fallen in price rapidly, especially after the investor community receives notice of an adverse development or when the earnings report is disappointing when compared against existing expectations. How do you tell the difference between one of those Mr. Market mispricings and a classic value trap?
I recently covered eBay as it witnessed one of the worst trading days in the corporation’s history, with the stock falling 12% down to $23. I found the drop attractive because the stock is making $2.10 per share and will likely make around $3 per share five years from now. That estimate assumes a little over 7% annual earnings per share growth. It would amount to: $2.10 in 2016, $2.25 in 2017, $2.41 in 2018, $2.59 in 2019, $2.78 in 2020, and then rounding up to $3 in 2021. That earnings stream is available for prospective owners on the public market right now if you are willing to capitalize the earnings at a figure of 11.
Over the course of five years, I anticipate that you will eventually come to see eBay trade at a valuation of 15x earnings. If that happens, and if eBay is earning around $3 per share, then shareholders stand to see the $23 share price in 2016 grant capital appreciation to $45 per share as core earnings grow a bit, the corporation buys back its own stock, and the valuation of the stock expands. Over a five-year holding period, this estimate implies returns of 14.37% annualized.
It seems to me that the life of a tech-oriented firm moves in waves: There is the post-IPO fervor that is usually tied to high growth that propels outrageous shareholder returns. Between 1998 and 2004, shareholders of eBay received compounded annual returns of 70.07% such that it would have taken only $59,000 in 1998 dollars to become an eBay millionaire six years later in 2004.
Then, the next wave is the “Oh wait, we’re crazy, have you seen we’ve been valuing this thing?” In 2004, eBay was at $58 per share while earning $0.57 per share in profits for a P/E ratio of 101. Even counting the Paypal spinoff of last July, the operational results at eBay proved exceptional: the business grew earnings per share at 19.5% over the next decade.
But investors didn’t get anywhere near what the operational results would merit because the starting period of the valuation was 101x earnings. That kind of bubbly absurdity takes a long, long, long time to burn off. As a result, eBay shareholders went on to receive shareholder returns of 1.84% through 2014.
This may sound tongue-in-cheek, but I mean it truly: Shareholders should be happy with those 1.84%. It has been an enormous feat of accomplishment that eBay shareholders have received positive returns from that price point. It was so offensively and egregiously high that investors probably should have lost around half of their investment over a ten-year period if eBay grew its earnings at around 10% during this decade, but they should be grateful that the earnings were so strong they nearly kept pace with inflation from that price point. Warning bells should go off when a large-cap, non-cyclical stock starts trading at around 30x earnings, and those bells should get darn loud somewhere around the 40x earnings mark at the latest. An investment takes on a ridiculous character after that valuation mark as daily trading becomes nothing more than greater-fool-theory speculation.
Then, after seeing the disappointing results, investors can’t get away from the stock fast enough without adequately recognizing that: (1) the poor investment results were driven more by valuation shifts rather than earnings concerns, and (2) even if earnings slow down, it is still better than what you get from many other contemplated investments. Coupled with a cheap price, the second wave creates shareholder wealth through above-average growth mixed with an attractive starting valuation. This is where eBay stock finds itself today.
On the hand, you have Amazon stock which trades in the $600s. People who perceive strength in Amazon’s groundbreaking internet ordering and rapid transportation facilities are right about their operations regarding the business. The issue for investors is that everyone else recognizes this, and the price of the stock bears no direct relationship to the profits earned by the mammoth online retailer.
In after-hours trading, the price of Amazon fell 13.5% from $635 to $550 as fourth-quarter profits came in at $1 per share which was below the analyst expectations of $1.56 per share. That brings Amazon’s profits to $1.24 for the year (like most retailers, Amazon’s are backloaded towards the Christmas season as fourth quarter profits are anywhere from tripled to quintupled the earnings during the other quarters). The current P/E ratio for the stock is 443.
Amazon stock is trickier to analyze because there is less clarity as to what “normalized earnings” truly are. The expectation is that, once Amazon entrenches itself with a large moat, it will begin raising the prices of its wares once the consumers are hooked. Amazon Prime is currently $99 to get people hooked to the act of purchasing everyday items online and then raise the prices once the habit is formed among a large enough customer base. If you buy 150 things online per year, and the price of Amazon Prime rises to $199, you are going to be a “sticky customer” because paying $199 still beats paying $598.50 if the average shipping charge is $3.99 and Amazon will be betting that you won’t be interested in reducing the amount of your online purchases on the site.
The follow-up question is whether Amazon with higher service charges is a clear-cut winner against competing firms like walmart.com or jet.com if the cost-effectiveness of using Amazon shifts. The Board must have some concerns about charging rates that would theoretically create profits consistent with Amazon’s reporting revenues otherwise they would be doing it by now.
But let’s assume, even from the low of after-hours trading, that Amazon is somehow able to compound at 10% in a justified way over the next five years. What would be necessary for that to happen? Let’s assume that the absolute highest fair value for the stock is 30x earnings, under the theory that the firm would be at the midpoint of normalizing earnings (thus giving it the unusual benefit of the doubt in valuation).
To appreciate at 10% annually from $550, the price of Amazon would need to be around $886 per share. At a valuation of 30x earnings, profits would need to be $29.53 per share. The analyst consensus for Amazon is a bit over $13 per share in profits in 2021. You can’t make the numbers work using traditional metrics to justify purchasing Amazon in a way that would meet the historical expectations of S&P 500 returns.
And keep in mind that I have drawn up very liberal assumptions that would assume a lot of best-case scenarios. Amazon’s current and projected earnings create too substantial of a gap between the expected profits and the current valuation. At the low of after-hours trading, Amazon was still trading at $257 billion.
Just as eBay went to perform well as a business from 2004-2014 without making shareholders rich because the share price was too absurdly high, Amazon shareholders are positioned for a similar experience. The business itself may very well perform exceptionally during the next ten years, but that growth won’t translate into increased shareholder riches because the Amazon shareholders of the past fifteen years reaped more wealth than the merits warranted.
As eBay has become fashionable, the profits remain there. It is expected to grow. When you have high single-digit earnings growth coupled with a valuation of 10.95x earnings, good things tend to come your way. Amazon shareholders will, at some point, learn a different lesson. Eventually, the price of the stock will reflect the cash flows generated by the business. There is going to be a substantial lag between what Amazon does as a business and what the shareholders actually experience, and there is no reason why you should put yourself in the situation of enduring that simply because the company is very fashionable with many analysts and commentators.