Can Amazon Grow into its Valuation?

By David Talley - June 27, 2012 | Tickers: AMZN, HD, TGT, WMT | 0 Comments

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It is no secret that Amazon (NASDAQ: AMZN), which trades at a P/E multiple of 180 times current earnings and 86 times forward earnings, is expensive. However, high growth companies often warrant their lofty multiples. Does Amazon’s exceptional earnings and revenue growth rates (both north of 30%) justify its multiple or is Amazon unjustifiably overpriced? 

Back of the Envelope
How much in revenues and what profit margin would Amazon need to justify its current value? Starting with an absurd example: if Amazon had $850 billion in sales (roughly the combined sales of Amazon, Wal-Mart (NYSE: WMT), Target (NYSE: TGT), Home Depot (NYSE: HD), Lowe’s, Best Buy, and Costco) and it current profit margin of 0.91%, Amazon would trade just under 13x earnings, comparable to Target’s and Wal-Mart’s 13x and 14.5x multiples, respectively.

Assuming Amazon can expand its profit margin to Home Depot’s industry leading 5.75%, Amazon would need revenues of $133 billion to achieve a P/E multiple of 13x. However, since Amazon’s margins have actually been shrinking, such expansion is almost as unbelievable as Amazon reaching $850 billion in sales. More realistically, Amazon could achieve a profit margin of 3% (just below Wal-Mart’s 3.68% and Target’s 4.15%) in the short term. With a 3% profit margin, Amazon would need around $255 billion in revenues to trade at a P/E of 13x. 

A Better Model
To model Amazon’s revenue going forward, I broke the revenues into six buckets (North American Media, International Media, North American Electronics and General Merchandise, International EGM, North American Other, and International Other) with their six different growth rates (17%, 22%, 44%, 42%, 66%, and 26%, respectively). Assuming no change in the growth rates in any of these segments, Amazon reaches $850 billion in sales around 2020, $255 billion in sales around 2017, and $133 billion in sales around 2015.

With this model, we get a more concrete view of what Amazon’s earnings could look like and can judge the assumptions required to get those earnings. Based on current growth rates and margins Amazon will grow into its valuation in eight years. Although it is unrealistic to assume these growth rates (especially those around 50%) to hold for eight years, an Amazon bull would claim that the company’s margins would expand over that time frame, becoming competitive with other retailers. Moreover, since Amazon does not have many of the costs of brick and mortar retailers, Amazon has the potential to have industry-leading margins.

If Amazon is able to match industry-leading margins, it will only take 3 years for Amazon to grow into its valuation. However, I do not think Amazon can both grow revenues and margins since it has largely used low prices to grow revenues. Anything shy of massive cost cutting measures (not a likely strategy for a growing company) would require price rises to increase margins to 5.75%.

The most likely scenario for Amazon going forward is for the company to grow revenues while competing on price. Eventually, Amazon will be able to start raising prices as competitors exit. This situation mirrors the mid-case presented above where Amazon grows into its valuation in five years. Even with these optimistic forecasts (continued growth in segments around 50% and tripling margins), it takes five years for Amazon to reach a cheap valuation. Even a 24x earnings multiple takes two years to achieve under these optimistic conditions.

Since Amazon is stuck competing on price and seems fine with its rising costs, I do not see significant margin expansion on the horizon. Moreover, I think Amazon will have trouble maintaining its high growth rate as revenues grow. Because I doubt the optimistic assumptions of my model and the model with those optimistic assumptions still finds Amazon richly valued, I would avoid or look to short Amazon.

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