Amazon.com, Inc. (AMZN) is the priciest stock in the entire S&P 500 if you measure it by the price-to-earnings ratio, the most widely used valuation metric in the stock market today.
AMZN stock goes for a remarkable 956 times trailing earnings, more than twice the next-most-expensive stock in the index, Noble Energy (NBL). When you remove all the energy companies trading at high multiples (due to depressed oil pries weighing on earnings), Netflix (NFLX) is the third-most-expensive stock in the S&P.
While Amazon’s current multiple sounds absolutely ridiculous, there’s a reason investors are willing to pay up for earnings. And it makes a lot more sense to pay 956 times times earnings for AMZN than it does to pay 296 times earnings for NFLX stock.
Here’s why.
Future Profitability vs. Content Costs
While taking a look at past earnings can be helpful, what investors really care about is future earnings. That makes the forward P/E ratio, which is calculated using consensus future earnings estimates, much more useful.
While NFLX has AMZN “beat” from a valuation perspective when we look at the trailing P/E — 296 vs. 956 — that advantage disappears when we examine each company’s forward P/E ratio. Netflix’s is 426, while Amazon’s is a “mere” 116.
That’s because Amazon has a lot of room to ramp up its margins, which the company has notoriously kept low in order to be a low-cost provider in e-commerce and a number of other industries. Not only does AMZN have room to improve margins, it has actually been doing so.
The AMZN stock price has more than doubled in 2015 after stringing together a series of impressive earnings beats, driven in a large part by the increasingly important role of Amazon Web Services, the company’s dominant, high-margin, fast-growing cloud computing segment. Revenues at AWS have been growing at an 80% for the past two quarters.
NFLX stock, while also up more than 100% year-to-date, doesn’t enjoy quite the same margin prospects. In fact, quite the opposite is true: Rising content costs, largely due to increased competition from Amazon Prime Video and Hulu, promise to be a problem for the streaming video leader for years to come.
Plus, many of Netflix’s business partners are getting sick and tired of seeing NFLX be so darn successful. Specifically, networks and content creators like Time Warner Inc (TWX), Twenty-First Century Fox (FOXA) and Discovery (DISCA), are all starting to consider putting their foot down.
How, exactly, will said foot come crashing down upon the earth? Simple: Networks will stop licensing their content to NFLX, who will then have to replace that content with original programming or simply suffer an eroding catalog.
At the end of the day, who’s to say what the fair price of either AMZN or NFLX is? They both deserve premiums to the market, and they’re both awfully difficult to value. But if I had to choose one to buy and one to short, I’m going long Amazon and short Netflix all day.
As of this writing, John Divine was long AMZN stock. You can follow him on Twitter at @divinebizkid or email him at editor@investorplace.com.
