Amazon’s $40 Stock Price Fall Justified

Amazon (AMZN) is one of the top five companies to come into existence during my lifetime. When we look back on the top storylines of the 1990s through 2010s, the growth of Amazon and its role in making e-commerce socially acceptable will be one of the storylines when we review the tale of our civilization decades from now.

But for the past few years, the problem has always been that Amazon’s valuation was so completely obscene that even highly optimistic expectations could still eventually translate into mediocre returns. Because stocks have valuations, you find yourself getting interested in things like Viacom, BP, and IBM even though you know other publicly traded corporations have higher growth rates.

My theory relating to Amazon’s valuation has been pretty simple. Over very long periods of time, all large-cap non-cylical stocks tend to converge towards a P/E ratio of about 20. Maybe some mega-caps are so special they can pull off a valuation of 25x earnings at that rate, but it’s hard to justify anything above that.

In Amazon’s case, it was trading at $814 per share yesterday morning while earning about $3.50 per share in annual profits. That’s a P/E ratio of 232x earnings for a $350-$300 billion company! To justify yesterday morning’s price, Amazon would need to increase profits ten-fold from the $3 per share range to the $33 per share range.

The silver lining is that Amazon has amazing top-line growth. It does business for about $131 billion worth of merchandise each year. The Prime brand is growing by 80% annually in India (which is crazy high growth), it is establishing itself as a grocer in Britain, and it is in the very early stages of competing with the post office for package deliveries using drones. The business has its hand on the pulse of economic development.

The problem relates to profit margins: Mass market retailers tend to earn around 3% profits on the total goods that circulate through them. Even if the explosive revenue growth continues and Amazon does $300 billion worth of business by 2030, that is only $9 billion in net profit. Even if profit margins at Amazon switch from uncharacteristically low to uncharacteristically high and Amazon brings in 5%, that is $15 billion in net profits. At a valuation of 25x earnings, that is a valuation of $375 billion. Right now, Amazon is valued at $366 billion.

See what I mean about the difficulty of making the math work? Even if you round up, and make everything optimistic in Amazon’s favor, you can’t help but conclude that Amazon is trading at a stock price that is ten to fifteen years ahead of a best-case scenario valuation.

The arc of investing history is that everything eventually comes down to profits per share. Because Amazon is justifiably trendy, and has very impressive revenue growth, the investor community has willingly overlooked the net profit figures. Last year, Amazon’s stock price fell from $670 to $500 for a 25% drop after a disappointing earnings report. You’re going to see more of that because the gap between Amazon’s current valuation and its current profits is extreme.

Amazon stock would be fun to own in your portfolio for a 20+ year time horizon. Unfortunately, everyone else has this insight and has bid the stock price up to the point where my previous statement no longer holds true. At some point, the current shareholders will receive returns that are far less than the growth of the business because the P/E ratio is due for significant compression ahead.

Originally posted 2016-10-28 16:53:36.

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