As I write this, Amazon.com, Inc. (NASDAQ:AMZN) stock trades at about $824 per share. For 2017, analyst consensus estimates are that AMZN stock will earn $7.25 per share for the full year. That gives Amazon stock an astronomical forward price-to-earnings ratio of nearly 62x. In comparison, the S&P 500 as a whole trades at about 17x next year’s earnings.
In other words, AMZN stock trades at a multiple nearly six times that of the average large-cap U.S. stock.
Of course, this isn’t a new phenomenon: For years, investors have considered Amazon stock overvalued based on a P/E ratio that has often been in the triple digits — and, not all that long ago, negative.
Yet AMZN stock seems to defy gravity: Shares are up 50% over the past year, 110% over the past three years and a stunning 340% over the past five years. The reason is that Amazon isn’t a stock that should be valued solely on next year’s earnings, or the price investors are paying for those earnings. That’s not because the market is crazy when it comes to AMZN stock and it’s not because the fundamentals “don’t matter”. It’s because Amazon is investing now for growth later — and that’s exactly what it should be doing.
AMZN’s Earnings Aren’t the Only Thing
It’s tempting to think that a stock with a lower P/E ratio is by definition “cheaper” than other stocks. Why would an investor pay 50x, or 100x, a year’s earnings when he or she could pay 15x, or 10x? Growth certainly matters.
Intuitively, an investor understands that 18x earnings for a bad business isn’t obviously better than, say, 22x earnings for a good business. In fact, it may be worse. But the P/E ratio for Amazon stock seems ridiculous on its face. AMZN is already the biggest retailer in the world; is it really going to show so much growth that it’s worth paying a 100x P/E? It would have to grow its profits by a factor of five just to get the multiple to 20x, which doesn’t sound cheap itself.
However, that type of analysis is generally too simplistic. A stock is valued based on the sum of all its future cash flows — not just next year’s. That’s true for AMZN stock, and it’s true for Macy’s Inc (NYSE:M) stock as well.
The fact that AMZN trades at 62x 2017 earnings and M trades at 10x doesn’t, in and of itself, prove anything. It seems almost certain that the earnings and cash flow attributed to AMZN stock will continue to rise; it seems highly likely that Macy’s earnings will, in contrast, fall. The rates at which those earnings rise or decline matters, of course, and those rates inform how investors value AMZN stock or M stock.
But whether a stock is valued at 100x P/E or 3x P/E, investors need to take a long-term outlook. And while it may not appear like it at first glance, that’s exactly what many AMZN stock holders are doing.
The Two Ways For Amazon Stock to Grow Earnings
Even those investors who are mostly bearish on Amazon stock would likely admit that Amazon’s earnings will continue to grow going forward. But the bearish argument — one that has been made for the better part of a decade — is that it’s almost impossible for AMZN earnings to grow that much. After all, as a company gets bigger, its growth rate fades, simply due to its size. (See Apple Inc. (NASDAQ:AAPL) for a perfect example.)
At some point, the optimism that keeps Amazon stock at nosebleed levels will fade — and AMZN stock will come back to Earth.
But that argument assumes that Amazon is at nosebleed levels, which may not be the case. The heavy-handed P/E ratio sounds highly stretched; however, according to AMZN’s most recent 10-Q, it generated $8.6 billion in free cash flow over the last four quarters. That implies a sub-50x multiple to free cash flow on a trailing basis — a slightly less intimidating multiple. And the focus on P/E ratio also ignores that there are two ways for Amazon to grow earnings.
The first is the standard way that companies grow earnings: higher sales and better margins. There’s little reason, barring an economic recession, to see AMZN’s sales declining. Even then, increased market share could allow Amazon to post revenue growth, if not at the 29% pace seen through the first three quarters of 2016.
There’s also reason to see AMZN’s margins expand considerably. Somewhat incredibly, on a GAAP basis, Amazon’s operating margin year-to-date is just 3.2%. Yet the company has built out an incredible distribution platform and it has invested billions of dollars in its Amazon Web Services business. Incremental sales thus should boost margins considerably; it takes very little in the way of investment to sell a few more items, or add another cloud customer.
AMZN still has years of benefits from the scale it has built out, and those benefits will continue to expand margins for some time, allowing for steady, and even explosive earnings and cash flow growth.
The second issue relative to current and 2017 earnings is that Amazon isn’t currently maximizing its profits. Rather, it is spending — sometimes wildly — on a variety of initiatives, offering everything from restaurant delivery to photo printing to Prime Video and Prime Music subscriptions.
Some of those efforts will work; many likely will fail. But looking at 2016 and 2017 earnings and not considering the impact of that spending is as short-term as buying AMZN stock in 2017 simply because it rose in 2016. Amazon’s operating expenses are on pace to increase almost $10 billion year-over-year in 2016. A good chunk of that is coming from hiring employees, marketing the new businesses and creating the distribution platforms for various projects.
Assume, then, that AMZN decided to focus on near-term earnings, instead of investing now for the future. Simply limiting that increase to $5 billion would come close to doubling Amazon’s earnings and cash flow next year. Ignoring that new spend ignores the ‘true’ earnings power of AMZN stock.
Bottom Line on AMZN Stock: It’s Complicated
This is not to say that Amazon stock is necessarily a buy. As a value investor myself, I still question the valuation of AMZN stock in my own way. But simply checking the P/E ratio for AMZN — or any other stock — is too simplistic. Trying to value Amazon stock is a messy, difficult, detailed endeavor. The Amazon Web Services business is vastly different from the price-sensitive, low-margin, online retail business. It’s not clear how much AMZN is spending on its new projects, and how much it could save.
It’s complicated. But so is investing the right way. And simply ignoring — or shorting — Amazon stock because of its P/E ratio isn’t the right way to do it. There are reasons to be optimistic, and pessimistic, toward AMZN stock, but those reasons go well beyond a single number.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.