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A Rational Response to an Amazon Bull

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Douglas Ehrman did a great job outlining a few of Amazon's (NASDAQ: AMZN) "hidden" sources of revenue. But I'm going to have to politely disagree that these "hidden sources" and Amazon's "growth prospects" make it a "buy" at today's astronomical valuation. Don't get me wrong, I think Amazon is an incredible company. But Amazon's growth prospects are already priced into the stock.

Warren Buffett's Margin of Safety

Warren Buffett has two fundamental principles that have taken center stage to his unparalleled performance as an investor. The first one is a fairly easy concept for investors to grasp: Invest only in companies with an economic moat, or a durable competitive advantage. But the second principle often receives the cold shoulder, especially when it is needed most: Always require a margin of safety.

A margin of safety simply refers to leaving room for error in your valuation. For example, after some fundamental analysis, a company appears to be worth $100 billion; An investor who requires a margin of safety would not buy the company unless it is trading at a discount to this estimate, e.g. a 25% margin of safety, or $75 billion. This discount helps the investor minimize his losses or even still make a profit when his or her estimates turn out to be too optimistic.

Return and Risk

Investors who bought Amazon in 2011 at an astronomical valuation have earned their keep. But does this mean they were right to do so? Sure, their investment turned out wonderful. But was the risk worth it? As Howard Marks, Chairman of Oaktree Capital, so eloquently points out, "Return has to be evaluated relative to the amount of risk taken to achieve it."

Returns have came easy over the past four years, as the S&P 500 rebounded from its recession lows with a whopping 99% gain. So investors have been able to profit without much thought to Warren Buffett's margin of safety. But the market is finally beginning to appear fairly valued as a whole, so it is extremely significant we begin to give Buffett's margin of safety the attention it deserves.

But we can't estimate a margin of safety if we don't approach investments fundamentally in the first place. So, my response to Mr. Ehrman's article will place fundamentals back where they belong--at the foundation of every investment decision.

A Few Rebuttals

Ehrman highlights three sources of revenue that he believes make Amazon a "buy."

  1. A potential loss of Amazon's sales tax privileges will not hurt Amazon's growth.
  2. Amazon Prime's streaming video service.
  3. Amazon's Web Services (AWS) division.

Below I'll offer a rebuttal to each of the above points, respectively.

1. Amazon investors don't seem to be too worried about the potential loss of tax privileges. At today's $225 price tag, the assumed free cash flow (FCF) growth rate by the market is 46.75%. How does this market expectation compare to past growth? Amazon's free cash flow hasn't grown much at all over the last few years, so apparently it's not a relevant measure. But even when we look at revenue, last quarter's year over year growth amounted to just 27%. In fact, Amazon did not achieve year over year revenue growth greater than 41% in any one year of the last ten years. So, the assumed FCF growth rate by the market of 46.75% is a far cry from reality.

In other words, this "privilege" is already priced into the stock--it's not hidden.

2. Mr. Ehrman points out that Amazon Prime's Instant Video service is "less expensive" than Netflix (NASDAQ: NFLX). But can we really say that Netflix is truly less expensive before we compare the quality of the respective content the customer is paying for?

Netflix easily prevails over Amazon when it comes to content for its streaming services; Consider this: Of Netflix's top ten TV shows, six are only on Netflix, and not available on Hulu, Amazon Prime's Instant Video, or Time Warner's HBO Go. The ratio is even higher for Netflix's top 50 TV shows.

The streaming movie/TV market is extremely competitive. Any upside to this revenue source is definitely priced into Amazon's stock price at today's valuation.

3. According to Amazon's financial statements, the AWS division represents only approximately 4.2% of net sales. With an assumed growth rate of 46.75% for Amazon's free cash flow, AWS is going to need to represent a much larger portion of net sales than this for it to have any significant impact on the bottom line, let alone merit Amazon's astronomical valuation.

A Few Thoughts on Opportunity Cost

Beyond economic moats and margin of safety, an investor should always keep in mind the opportunity cost of any investment. Why pay such a premium for a tech company with streaming video and cloud services when you could buy Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG), or Microsoft (NASDAQ: MSFT), all competing for these same markets (except Microsoft in streaming movies/TV shows), at a much cheaper price. Yes, each company is competing in these markets in a different way, but their much more conservative valuations at least leave less room for speculation.

Valuation

Enter the FCF yield, my favorite easy-to-use valuation metric. The FCF yield shows you what percentage of a company's share price is represented by the cold, hard cash it's churning out. The higher this percentage, the better.

AMZN Free Cash Flow Yield data by YCharts

Measured by FCF yield, both Amazon and Netflix are trading around their all-time premiums with FCF yields of just 1%.

Even more unruly, measured in terms of profitability, Amazon pales in comparison to Netflix, Apple, Microsoft, and Google. Amazon's low-margin, high volume online retail services will always keep Amazon's profit margins very low. Take a look at their FCF-sales ratios (free cash flow/revenue)–once again, the higher the better:

Company TTM FCF-Sales Ratio
Amazon 1.8%
Netflix 5.7%
Apple 26.4%
Microsoft 40.2%
Google 26.6%


The Bottom Line

Amazon is a great company, but it's a risky stock with speculation priced into its current valuation. I think there are better places out there for an investor's money. If tech is your thing, take a closer look at Apple, Microsoft, and Google. Just because their growth prospects are not as delightful or certain doesn't mean they are not better investments.

And one last note: leaving a margin for error will give you staying power when you need it most. If there is anything certain about historical returns of investors, those with lower turnover perform better. So don't invest in Amazon based on growth prospects alone; always require a margin of safety. There is no replacement for fundamental analysis.


DanielSparks owns shares of Apple. The Motley Fool owns shares of Apple, Amazon.com, Google, Microsoft, and Netflix. Motley Fool newsletter services recommend Apple, Amazon.com, Google, Microsoft, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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