How Much Would You Pay for Mighty Amazon?

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

One of the investment tenets observed by many value investors teaches that good companies may not all be good investments. Amazon (NASDAQ: AMZN), at its current imposing price level, increasingly looks like what such an investment rule intends to illustrate. While few will disagree that Amazon is a great company, many may have doubts when betting their own money on the stock, now that it's price is in the upper-$200 range and it has a mind-boggling, abnormally high P/E ratio. In comparison, Apple (NASDAQ: AAPL), the most valuable company on the market (but having recently fallen to within the lower-$500 range), now has a quite subdued P/E ratio below the long-term market average. Google (NASDAQ: GOOG), another high-priced stock now reaching the $750 threshold, also has a P/E ratio that may be still in line with some value investors’ measure.

Amazon has had consistent revenue growth over the years, achieving an annual sales increase of approximately 30 to 40 percent for the past five years. This is arguably the result of the company’s continued business expansion and aggressive capital investment. Thus, understandably, some investors likely have put their high-valuation price tag on Amazon stock largely based on the company’s full-force growth prospect. But companies delivering impressive sales results can still be losing money, or making little profit.

For investors, a company’s value ultimately resides within its business’ earning power. In the case of Amazon, given the enormity of the cost of running its business, earnings are one thing that has eluded the company. Operating profit margins for Amazon have been notoriously thin, usually fetching a mere five percent, and less than two percent for 2011. The company even lost money in the third quarter of 2012. Given its sheer size, Amazon at its current level of earnings may eventually run short of what is required for capital expenditures and other investments, noticeably on its warehouses and order fulfillment centers around the country.

Business expansion over the years, both horizontally and vertically, has helped remake the original online book seller. Today it’s impossible to label Amazon under one single business category. While its online book business continues to challenge the rest of the book industry, Amazon has evolved into an all-encompassing e-commerce giant that, along with its affiliates around the globe, can offer almost anything to consumers with convenience, value, and quality. Some may say that Amazon is a lot like a digital version of Wal-Mart, another low-margin business. Aggressive pricing may have helped Amazon win competition, but it may have also played down its profitability.

The company’s online book business has also evolved to include an online publishing service today, a way for people to self-promote their writing works absent the help of traditional publishers. Amazon's online book publishing is further solidifying the e-book phenomenon that followed its successful introduction of the electronic book reading. But however a revolutionary role that Amazon has played in the book business, the huge cost of technological undertaking, including the creation of its Kindle content delivery mechanism, and the prevailing practice of ultra-low pricing on e-books may have hindered the economics of its e-book business.

Building on the experience of running its enormous Web operations a with high level of Internet data support and information processing, Amazon has emerged as a major player in cloud service and data center management. In addition to self-supplying networking capability to power its own websites, Amazon also provides data storage and hosting services to other companies. The business involves physically setting up large-scale servers and other network equipment in different places, and thus requires intensive capital investments. Depending on the demand for its data services, fees earned may take years to pay back capital outlays, a potential drag on Amazon’s profitability in the interim.

In comparison, Apple and Google are more profitable companies. Built around its devices, Apple's business is more concentrated than Amazon’s sprawling undertakings. Apple makes money when a device is sold, and again makes money when the same device is used as a platform by third-parties as an application-launch pad. Unlike Amazon selling its Kindel device as a lure for customers to buy its other services, Apple has all the intention to earn as much profit as possible from every device it sells. Google has also been able to maintain a wider operating profit margin than Amazon--above 30 percent in four of the last five years. Google’s steady focus on increasing earnings from ad sales is an unstated driving force behind its continually introducing new tools and services.

Many consumers are careful not to overpay for goods or services, but oddly enough fewer investors are concerned about overvaluing an investment. It’s true that an overvalued investment may not lose its nominal value for some time and can even earn investors high returns as long as it is still attracting continued overvaluation from other investors. But it can be a risky bet to rely on others’ unpredictable behaviors rather than a business’ fundamental performance. At its current valuation, it might be just a hefty price to pay for even the mighty Amazon.

JJtheArdent has no position in any stocks mentioned. The Motley Fool recommends, Apple, and Google. The Motley Fool owns shares of, Apple, and Google. 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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