I recently wrote to you about how the drop earlier this week GlaxoSmithKline wasn’t a big deal in the slightest, and how a hypothetical family in 2019 reviewing their reinvested GlaxoSmithKline dividends may actually look back fondly on the share price drop in the middle of Summer 2014 as it provided an opportunity to get a lower price, and thus a higher ownership position in the form of additional shares due to the decline.
Now, I want to discuss a company that does not share GlaxoSmithKline’s outlook. If you follow Amazon, you may have seen that the company reported a $126 million loss for the second quarter of 2014. Although the stock closed the day at $358 per share, it fell $38 in after hours trading to $320 per share, for a drop in the 10-11% range.
Here’s a quick, back of the envelope trick to help you figure out when a stock is terribly overpriced: figure out what a fair long-term P/E multiple would be for the stock, compare it to current profits, add in the dividend value, and see what the situation looks like.
In this case, Amazon doesn’t pay a dividend or express an indication to do so, so we can leave that out of the analysis. As a general rule, the long-term P/E ratio for even a rapidly growing megacap is somewhere around 25x profits (and these are probably the highest sustainable assumptions).
Because the company is currently losing money, we’ll make an even more optimistic projection by using next year’s estimated profits of $3.00 per share. If you look at the current share price of $320 per share and divide it by 25, you would get earnings per share of $12.80 (this year, Amazon is expected to make $1.00 per share).
Put simply, to merely breakeven on the current $320 per share price in five years, Amazon would need to triple its profits between now and next year, and then quadruple them in the five years after that. If the company traded at 25x profits at that time, you would make $0 between your July 2014 purchase price and the expected 2019-2020 share price. I have no idea what Amazon’s stock will do this year or next, or the year after that, but the current stock price is not supported by profits—it’s supported by the promise of future profits in which Amazon dominates the world, squeezes out the competition, and then jacks up the prices of everything to secure higher margins once it has a monopoly on electronic selling. The problem for investors is that, even if Amazon executes on this strategy (and that’s a big if, because there is also going to be someone there to compete, be it EBay or Wal-Mart) the share price got so ahead of itself in 2014 that the inevitable P/E compression would suck up all your growth.
This is a very different situation from GlaxoSmithKline, a company making $9 billion in profits, returning 2/3 of them to shareholders as a cash dividend, and then trading at 12-13x profits. There is a connection—a nexus—between the profits earned by the company and the stock price. Amazon is going to make, what, $500 million this year? That puts it at something like 450-500x current profits. That’s late 1990s stuff. What was Charlie Munger’s famous advice? “Don’t do cocaine. Don’t race trains. And avoid all AIDS situations.” Let’s add a fourth. “Don’t pay 500x current profits for a stock.”
Originally posted 2014-07-25 02:47:40.