Amazon: Still Worth its P/E

By Daniel Sparks - August 23, 2012 | Tickers: AMZN, BIDU, GOOG, PCLN | 0 Comments

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Every once in a while there are companies that simply defy gravity. They trade at astronomical P/Es that scare many investors away ... but their stock price, along with the value of the underlying business, just keeps rising year after year. Many times value investors like myself will respond in one of two ways:

1. Kick yourself for missing the opportunity.
2. Justify your actions with the excuse that it was simply just too risky.

I'd say that the second reaction is the right thing to do 95% of the time. But every once and a while there is a stock that trades at insane P/Es for a very good reason.

When a stock meets these 3 requirements, it deserves a lofty valuation.

1. A wide economic moat (check out: 5 Ways To Identify Wide Economic Moats). Any business that has a lofty valuation should only be bought as a long-term investment. Short-term disappointments in stocks like these can cause wild fluctuations. This is why you must require a sustainable competitive advantage and let it pay off for you in the long haul.
2. Exponential growth patterns. To explain, I will quote myself (pompous, I know): "An understanding of Moore's Law and exponential curves highlights a 21st century breed of companies that are well deserving of their 'lofty' price tags." Believe it or not, our brains are not used to comprehending exponential patterns. Steven Kotler, author of Abundance, states this point like a champ: "Today's global and exponential world is very different from the one that our brain evolved to comprehend" (for more on this topic, check out this article at my blog: Moore's Law, Exponential Curves, and . . . Opportunity?).
3. Plenty of room for growth and maturing. Take a look at where the growth is coming from. Do your own SWOT (strength, weaknesses, opportunities, threats) analysis to assess demand. If you would like to see an example of a SWOT analysis I did, check it out here.

One business that meets all 3 of these requirements comes immediately to mind: Amazon (NASDAQ: AMZN).

I'll discuss Amazon based on each of 3 criteria listed above:

Economic Moat: Amazon has been nothing but disruptive to hundreds of retailers. Its customer-first orientation and relentless innovation to remain the world's best online retailer have brought it much success. Amazon Prime and its 2-day shipping has created a highly loyal group of customers. Amazon's economies of scale, brand power, and outstanding distribution give it a wide economic moat.

Exponential growth patterns: Demand is growing, and it's growing fast.

AMZN Revenue TTM data by YCharts

Plenty of room for growth and maturing: Amazon has plenty of room for growth as more and more consumers begin to shop online for products normally bought at local stores. Even more convincing, Amazon's economies of scale and its ever expanding, excellent distribution system might very well make same-day shipping a reality (see: I Want it Today). Plus, Amazon is still a new market entrant when it comes to Amazon branded consumer electronics (Kindle), yet it is already a competitor to be reckoned with.

Other stocks worth their lofty P/Es: Priceline.com (NASDAQ: PCLN), Google (NASDAQ: GOOG), and Baidu (NASDAQ: BIDU). All three have abnormally high profit margins and exponentially growing revenue.

GOOG Gross Profit Margin data by YCharts

BIDU Revenue TTM data by YCharts

GOOG Revenue TTM data by YCharts

Priceline.com

There is plenty of room for growth left at Priceline.com. Despite economic uncertainty, year over year profit from international operations increased 53% on a local currency basis. There is no apparent slow down -- Priceline.com's overall TTM income increased 41.2% year over year. CEO Jeffery Boyd explained during the company's most recent earnings call that it plans to continue to expand the business through "geographic expansion and acquisition of hotels and accommodations, product and service innovation, and customer acquisition" (source: sec filing).

Google

With the introduction of the Nexus 7, Google has made a strong entrance into the tablet market. Furthermore, its acquisition of Motorola Mobility on May 22 will further help Google penetrate this fast growing market. Google CEO Larry Page commented on this acquisition and its related plans in its most recent earnings release, "we're excited about the potential to build great devices for users" (source: sec filing). I have no doubt that Google plans to make the most of this acquisition and it should add another fast-growing market to Google's already fast-growing and profitable business model.

Baidu

Total revenues for Baidu's most recent quarter increased 59.8% over the corresponding quarter in 2011. There is plenty of room for growth left for Baidu. In addition to expanding their customer base they plan to "maintain momentum by rolling out optimized sales processes and more advanced tools to help current and potential customers increase returns on their online marketing spending." They will "also continue to actively explore the vast opportunities in China's fast-emerging mobile internet and cloud sectors" (source: sec filing).

Next time you see a high-flying stock, take a minute to decide whether it has a moat or not, figure out where the growth is coming from, and decide how much room there is left for the business to grow. That high-flying stock just might be undervalued. Don't automatically rule them all out!

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