How to Value Amazon: An Unconventional Approach

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

Warning. This article takes a completely unconventional approach to stock valuation. I think it's time we approach Amazon (NASDAQ: AMZN) from another angle.

The unconventional approach

What exactly is my unconventional approach to valuing Amazon? The model itself is nothing out of the ordinary. I project future cash flows and discount them by the time value of money to estimate the fair value of the business. What I do different, however, is use cash from operations as a basis for the valuation.

Typically investors will either use earnings or free cash flow (FCF) in a discounted cash flow valuation. In fact, in almost every other valuation I've ever completed I used FCF. So why would I use cash from operations instead of free cash flow in an Amazon valuation? Simple. Capital expenditures (CapEx) literally drives every aspect of growth at Amazon. CapEx enables the company to capture fast-growing demand and continue to widen its moat.

Please, spend more money

In other words, I want Amazon to increase CapEx spending. The company has earned my trust. Plus, the market outlook for e-commerce is booming on every aspect.

Amazon's ability to reward investors handsomely is evident in the company's five year average return on invested capital (ROIC), amounting to 19.2%. Compare this to Wal-Mart's (NYSE: WMT) despite the company's massive scale, its ROIC is nearly halved, at 11.3%. But maybe it's not fair to compare Wal-Mart to Amazon. After all, Wal-Mart is getting old and slow. But even Williams Sonoma (NYSE: WSM), renowned for its retail success and its successful e-commerce execution, has a five year average ROIC of just 12.6%.

Black Friday 2012 offers a prime example of why Amazon needs to continue to drastically increase its CapEx spending. Amazon not only experienced the most traffic of the five retail stores with the highest online traffic on Black Friday, but it also experienced the highest year-over-year growth rate in number of visitors on Black Friday. So not only is Amazon an e-commerce leader, it is actually expanding its lead. To capture growth on this trajectory, Amazon will need to spend more money.

The result of Amazon's successful CapEx spending? An explosion in both the price of Amazon's stock and its book value as the company captures demand and widens its moat in a booming market:

<img src="http://media.ycharts.com/charts/0d3cf7fc4724862b9f68fc2a50f1236f.png" />

AMZN Book Value data by YCharts

And the market opportunity going forward is astounding. US e-commerce sales still amount to a paltry 5.2% of total retail sales. Even better, e-commerce sales are growing at an annualized rate of about 18%.

Investors should rejoice in every dollar Amazon spends on CapEx.

Amazon valuation

So, by using cash from operations as opposed to FCF in projecting future cash flows I am essentially excluding CapEx from the equation. This makes sense because CapEx, at this point, is just as valuable as cash. Also, when Amazon finally slows (will I still be alive?) CapEx will dramatically decrease as a percentage of cash from operations and the company's FCF levels will increase.

For the math geeks out there, let me quickly break down the inputs I used in my discounted cash flow valuation. Based on a historical 5 year average growth rate in cash from operations of over 19%, I projected Amazon's cash from operations to increase 10% annually over the next ten years. In my opinion, this is a very conservative projection.

I used a discount rate of 9% to measure the time value of money and to compensate myself for the risk of investing in the stock market. Since Amazon will likely not cease to exist in ten years I used a perpetuity rate of 3%, projecting cash flows to settle at a 3% growth rate (equal to the historical rate of inflation) beyond ten years.

When I plugged these numbers into my discounted cash flow spreadsheet, I received surprising results. The fair value of Amazon shares? $270.

How not to value Amazon

Using other metrics, Amazon's valuation just doesn't make sense. Especially when compared side-by-side with competitors.

Comparing by P/E, you might end up with a headache.  Currently, Amazon doesn't even have a P/E since it has reported a loss over the twelve trailing months. Even if you used Amazon's three year average earnings in the P/E ratio in order to get a positive number, the P/E ratio approaches a whopping 200. According to Morningstar, the company's forward P/E is 68, still enormous.

Wal-Mart and Williams Sonoma's P/E's tell quite a different story. Wal-Mart's forward P/E is 12.5 (as expected for a slow growing company).  William's Sonoma's forward P/E amounts to 14.9.

What about price-to-sales? This is a bit more realistic, but still makes Amazon look a bit expensive. Amazon trades at a price equal to 2.1 times sales. Williams Sonoma and Wal-Mart have price-to-sales ratios of 1.2 and .5, respectively.

Name your valuation metric and it will likely yield some wacky results.

The bottom line

Amazon is a growth company. Treat it like one. That doesn't mean investors should ignore valuation altogether. But since CapEx spending is so crucial to Amazon's growth, investors should rely on cash from operations in projecting future cash flows – not free cash flow. Ultimately it's Amazon's CapEx that will yield the company's future growth and help the firm capture market share and widen its moat. Hence its exclusion in my projections of Amazon's cash flows. 

Is my approach too radical? What do you think?


Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Williams-Sonoma. The Motley Fool owns shares of Amazon.com. 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.

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