The stock price history of Amazon stock is truly an amazing sight to behold. Shares of AMZN, which traded at $42 as recently as 2008, have compounded at an eye-popping 43% annualized over the past nine years to turn every $10,000 invested into $190,000. Jeff Bezos has followed Warren Buffett’s advice and filled Amazon’s pre-existing moat with alligators, piranhas, and spiked fences awaiting on the other side. Heck, they’re even securing patents for Star Wars-type processing centers that hover above the atmosphere.
And yet, if you are a student of the value investing espoused by Benjamin Graham, you can’t help but notice one fundamental fact about Amazon that makes it exceedingly difficult to value. It has no profits! There is this yawning, widening, maddening gap between the revenue and stock price history of Amazon and the lack of profit growth at the colossal online retailer.
Revenues have grown from $10 billion to $134 billion in the past twelve years. The market cap has increased from $10 billion to something approaching $400 billion. And yet, Amazon’s profits are below $3 billion. That is 133x earnings for one of the ten largest corporations in the United States. History shows you tend to get into trouble when you pay much more than 25x earnings for even an excellent, fast-growing company.
For Amazon to trade at a non-overpriced valuation, it would need to almost immediately start making $16 billion. The best analyst estimates call for Amazon to make $12 billion in 2022. That means even if optimistic scenarios prove true, Amazon is currently trading at 33x five years from now. If you want to earn a positive return over the next half-decade, it will either need to grow profits above the $12 billion mark or trade at a valuation greater than 33x earnings. That’s the mathematical reality that asserts itself upon nearly every large stock over the long term.
The appeal of Graham’s teachings on value investing is that they remind us that successful investing isn’t just about identifying the best companies. It is about trying to acquire as much future earnings power at the lowest possible price. The fact that the great companies are priced accordingly and the second-class firms are also priced accordingly is what makes it all so fascinating.
About a year ago—last January 28th—I shared with you my thoughts after Amazon’s erstwhile competitor eBay reported poor earnings and saw its stock price collapse. I argued as follows about eBay stock’s valuation:
“This is a stock that dipped below 20x earnings briefly during the financial crisis, and otherwise traded between 20x earnings and 40x earnings during the past decade. And yet, it reports stagnant revenues in the aftermath of the Paypal spinoff, and it suddenly gets labelled old tech and nobody wants it.
This is value investing in all its glory–you’re buying a very lucrative firm, it is growing profits, and the valuation is dirt cheap even though the financial press doesn’t give a hoot about the stock these days. A valuation of $23 per share compared to $2.10 per share in profits is a P/E ratio of 10.95x earnings.
That is a very solid 36% to 54% margin of safety if you conclude as I do that the proper valuation for the firm is 15x earnings to 17x earnings long term.
Since that day, eBay stock is up 32% annualized and Amazon stock is up 26% annualized. If you paid to attention to the commentary of most pundits, this isn’t supposed to happen. Amazon is out there shaking up the industry and putting the fear into the eyes of brick-and-mortar, and yet, we can identify a point at which eBay has outperformed it. It turns out that eBays journey from deep value to fair value represented more wealth creation than Amazon stock’s journey from overpriced to more overpriced.
And I would argue that eBay did it in a less risky way. When a profitable, non-cyclical business falls to 10x earnings, it is not that terribly difficult to figure out that capital appreciation awaits when business results improve a bit and the valuation swings a wide pendulum to get back to a price where it needs to be.
With Amazon, I have no idea how you value a business that is trading at a multiple that has never been sustained for a corporation of its size. The best bet for shareholders is that Amazon can raise the price of Amazon Prime and start collecting much larger transaction fees on its good as its market position becomes more and more dominant. But if Amazon could do this without eroding its market position, why hasn’t it done so?
A fatal investing flaw that I see all the time is that people take their cues from recent stock price history. Amazon rises from ten-fold, and people assume that the valuation must be fair. Gilead falls to the $74 range, and suddenly, no one wants it. If Amazon were trading at $400 and Gilead were trading at $125, do you really think the sentiment surrounding the companies would be the same? People look at recent price action to infer what the stocks are going to do in the future.
Amazon is an extraordinary business with a stock price that has absolutely no connection with reality. If Amazon more than doubles profits to the $8 billion range, is the investor community going to value it as a trillion-dollar enterprise? That’s only a little bit more than what Berkshire Hathaway makes in a quarter these days. If you plan on holding Amazon stock for more than five years, you need to either reach the conclusion that the business will make tens of billions in profits or the P/E ratio will continue not to matter. If the numbers don’t work even when using the most optimal of scenarios, you should recognize that any impetus you feel to purchase Amazon stock is mostly an emotional impulse driven by recent price action and an impressive story.