Here’s Why We Think Amazon’s Stock Trades At Lofty Valuations

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AMZN: Amazon logo
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Amazon

We have recently revised our price estimate for Amazon’s (NASDAQ:AMZN) stock from $303 to $263, as we expect its profitability outlook to remain grim over our forecast period. We expect the company’s top-line growth to slow-down in the coming years due to tougher year-over-year comparisons. Coupled with increased expenses, we think this will make it difficult for Amazon to raise its margins during the coming years.

We think the market seems to consistently over-price Amazon stock, as investors lay greater emphasis on factors other than financial strength and business fundamentals in their valuation of the company, in our view. Even though Amazon’s profitability has steadily deteriorated over the last 10 years, its stock has appreciated by over 600% and is currently trading at very-high valuation multiples. While we understand that Amazon has a long-term strategy in place and does not pay much attention to short-term goals, we also suspect that certain behavioral characteristics among investors could be responsible for the company’s long-standing high valuation. We discuss such behavioral biases pertaining to Amazon’s stock in this article.

We think that the low possibility of very-high returns associated with Amazon’s stock, due to its investments in various businesses and increase in market share, attracts investors leading to over-pricing of the company’s stock. In addition, the low level of transparency in the company’s financial results leads to a high degree of speculation. If Amazon starts providing more information on its financial results and scales down its investment strategy, its expected return could become much more predictable leading to a lower valuation for the shares, in our view. Investors’ love affair with Amazon’s “invest now, profits later” strategy seems to be increasingly waning, and we think Amazon will have to show a material improvement in profitability during the coming quarters for its stock price to surge higher this year.

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Our $263 price estimate for Amazon’s stock, represents near-10% downside to the current market price.

See our complete analysis for Amazon

During 2005–2011, Amazon’s stock traded at an average PE ratio of 76x, as compared to the S&P 500 average-PE ratio of 16x. During 2013, its PE ratio was around 667x, against 19x for the broader market. The same story holds true when we analyze from a price/cash flow valuation perspective. Amazon’s average P/CF multiple stood at 24x during 2005–2014, as compared to S&P 500’s average multiple of 10x (All valuation ratios as reported by Morningstar). Its high valuation has sustained despite its profitability slipping consistently during this period. Amazon’s average operating margin was 4.4% during 2005–2010, and dropped to 1.0% by 2013. During the last twelve months, this margin has further declined to a dismal 0.1%.

Investors, as per traditional finance theory principles, act rationally, display risk aversion and maximize their utility. But in reality, they commonly display several behavioral traits such as loss aversion, tend to over-concentrate on high-risk and low-risk securities (as compared to medium-risk investments), and gravitate towards lottery-like stocks (behavioral finance theory). We seek to analyse Amazon’s sky-high valuation through the latter principles in this thought piece.

Here are some of the reasons why we think Amazon’s investors could be exhibiting behavioral biases in their valuation of Amazon’s stock.

Low-Probability Of Very High Return Attracts Investors

Under the behavioral finance theory, investors tend to give high preference for stocks that offer low probability of very high returns (lottery-like payoffs), which often results in such stocks being overpriced in the market. Amazon also displays some of the these characteristics, in our view. With Amazon’s strategy of chasing a myriad of growth opportunities in diverse areas such as e-commerce, hardware, entertainment, consumer packaged goods’, then grocery business, etc., there is always a small possibility of some of these investments paying off highly, which makes the company attractive to investors. Additionally, a slight probability of Amazon dominating the global e-commerce market in the later future, with its low pricing strategy and other competitive advantages, also allures investors.

Amazon, on its part, maintains low transparency in its financial results. It provides minimal information on products and services such as Prime, the Fire Phone, Kindle and Amazon Web Services, leaving the market to speculate on the performance of these businesses.

Less Transparency Makes Expected Return More Difficult To Estimate

Amazon’s very wide guidance range on its future results also leads to increased speculation in the market. During the last quarterly results, Amazon guided to a revenue growth in the range of 7% and 18% annually in the last quarter of 2014. Additionally, it pegged operating income (loss) in a wide range of between -$570 million and +$430 million during the quarter. This makes the company’s expected earnings per share (EPS) difficult to estimate.

We think that in the  event Amazon starts providing more information on its businesses, it will make it’s expected return less difficult to forecast, which could result in a correction in its market valuation. Moreover, in an event where Amazon starts scaling down on its investments and focuses only on its key businesses, its future expected return could become easier to estimate, thus reducing its lofty market valuation. Positive news announcements by Amazon pertaining to investments in new businesses and technologies, price hikes in certain businesses, successful hardware sales etc. have also helped buttressed the company’s strong brand recognition among investors.

So What Does This Mean For The Company’s Investors?

While these behavioral biases lead to a temporary aberration in stock prices, over the longer-run, a company needs to justify its high valuations with corresponding growth in business fundamentals. We think it will become critical for Amazon to improve its margins in the coming quarters for its stock price to move higher.  During the last few quarters, Amazon’s share price has traded down post each earning announcement as market participants have become increasingly concerned with the company’s lack of profits. Hence, we’d advise investors to monitor the company’s margins closely in the future as continued slippage in the same, could send Amazon’s stock tumbling.


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