Don't Pay Tomorrow's Price Today

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

Amazon (NASDAQ: AMZN) is a company which seems to draw strong opinions from both sides. Some claim that Amazon is grossly overvalued with terrible margins and an inability to generate substantial profits. Others claim that Amazon is simply heavily investing in its future and that the company could make huge profits if it wanted to. They say revenue is the number to care about, not profits.

The problem with Amazon is that you're paying tomorrow's price today for the stock. As of the end of the third quarter of 2012 TTM revenue stood at $57.26 billion. COGS ate up $43.67 billion of this, or 76.3%, while operating expenses ate up another $13.06 billion, or 22.8%. These percentages for COGS and operating expenses have remained roughly the same over the past decade. This leaves an operating income (before interest and taxes) of $531 million, or just 0.93% of revenue. Net income came in at a paltry $40 million, or 0.07% of revenue.

Free cash flow has looked a bit better. In the TTM period FCF was $1.06 billion, down from $2.09 billion in 2011. The average FCF in the 5-year period ending in 2011 was $2.01 billion, or 3.5% of the TTM revenue.

What has seen tremendous growth is Amazon's revenue. Over the last decade revenue has grown at an annualized rate of 28.4%. The 5-year annualized growth rate is slightly lower at 26.5%. Both COGS and operating expenses as a percentage of revenue have risen at about the same rate.

The current stock price is $267.94 per share with a total diluted share count of 461 million, resulting in a market capitalization of $123.5 billion. Let's calculate some TTM ratios:

RatioResult
Price/Sales 2.16
Price/Gross Profit 9.09
Price/Operating Income 232.6
Price/Net Income 3087.5
Price/Operating Cash Flow 36.7
Price/Free Cash Flow 116.6
Price/Owner Earnings 280.0

Data from Morningstar

These numbers look pretty terrible. An interesting point is that Amazon trades at 9x gross profit. For comparison, Apple (NASDAQ: AAPL), another company which has seen the same kind of incredible revenue growth, was trading at about 10x gross profit at the end fiscal 2012 (this was right around Apple's all time high of $700 per share). The difference, of course, is that Apple was also trading at about 14-15 times FCF as opposed to Amazon's 116. In other words, Apple generates incredible profits while Amazon does not. Why, then, does the market not care about Amazon's profits? If Apple were valued at the same P/FCF ratio as Amazon it would have a market cap of $4.8 trillion! That's trillion, with a 'T'.

Let's conduct a little experiment. Imagine that Amazon's revenue continues to grow at 26.5% annually. Along with that, let's say that free cash flow grows at the same rate, and I'll use the 5-year average FCF of $2.01 billion as a starting point. Here's the question: how long does it take for Amazon to generate enough FCF to be valued at 15x FCF based on today's market price.

Answer: 6 years

And that sums up the problem with Amazon. You're paying tomorrow's price today. All of the expected revenue growth in the world doesn't mean anything if you're overpaying by so much. People will claim that the Price/Sales ratio, which is 2.16, is reasonable for a retailer. Well, if that's the case then Best Buy, which puts up similar FCF numbers to Amazon, should be worth about 10 times its current market capitalization. Ultimately, sales mean absolutely nothing if they don't generate profits. I couldn't care less about sales. Profit is what matters.

The Bottom Line

People get emotional about Amazon. They start looking for any metric that justifies their position. In Amazon's case, that metric is revenue. Amazon is a company which is very good at growing sales. But that's not the kind of company I want to own. I want to own a company which is very good at growing profit. As a shareholder, you own the right to a share of the profits, not the sales. So do yourself a favor: don't pay tomorrow's price today.


TheBargainBin owns shares of Best Buy. The Motley Fool recommends Amazon.com and Apple. The Motley Fool owns shares of Amazon.com and Apple. 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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