The Metric Amazon Can't Ignore Forever

Jon 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 the undisputed heavyweight of internet marketplaces.  This company is absolutely phenomenal in terms of revenue, website traffic, growth and a variety of other factors.  Amazon is also a living fossil in a way.  They are one of the last companies leftover from the bubble.  They never folded, and for good reason.  While many stocks were speculative, Amazon actually sells stuff and makes money.  Look at the revenue over the past five years: 

<img src="" />

data by YCharts

Whatever praise we could sing to Amazon's credit needs to be tempered with one oft forgotten metric when considering this as an investment.  There will come a day when Amazon's p/e ratio will finally catch up with them.

The problem

As an investor, I believe that Amazon is extremely overpriced when compared with competitors.

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Market Cap</strong></td> <td><strong>Price/Earnings</strong></td> <td><strong>Forward P/E</strong></td> </tr> <tr> <td>Amazon</td> <td>123.26 Billion</td> <td>3,240</td> <td>156.39</td> </tr> <tr> <td><strong>eBay</strong> <span class="ticker" data-id="203360">(NASDAQ: <a href="">EBAY</a>)</span></td> <td>70.15 Billion</td> <td>27.24</td> <td>16.94</td> </tr> <tr> <td><strong>Overstock</strong> <span class="ticker" data-id="204851">(NASDAQ: <a href="">OSTK</a>)</span></td> <td>345.37 Million</td> <td>144.41</td> <td>17.75</td> </tr> <tr> <td><strong>Mercadolibre</strong> <span class="ticker" data-id="216568">(NASDAQ: <a href="">MELI</a>)</span></td> <td>3.9 Billion</td> <td>42.18</td> <td>32.09</td> </tr> </tbody> </table>


When looked at in terms of just the forward price to earnings ratio, Amazon is five times more expensive than Mercadolibre and 9 times more expensive than eBay.  I'll be the first to admit that Amazon's current price to earnings of over 3,000 is a little skewed, but the forward p/e still tells a pretty bleak tale.  In short, Amazon's price to earnings must come down.

There are only two ways to lower a price to earnings ration that I know of.

  1. The net income goes up
  2. The price/share goes down

Higher net income

If Amazon is to push net income higher, there are two ways they can go about it:

  1. Grow revenue with current profit margin
  2. Increase profit margin

In reality, businesses use a combination of these two options.  The goal is always to increase revenue and margins simultaneously.

Amazon historically has had pretty dismal profit margins.  The goal for this company is geared more towards volume instead of profit margin or net income.  Just look at the profit margin over the past ten years:

<img src="" />

data by YCharts

Amazon here is at the bottom of our list in terms of profit margins.  And in fact, I find it unlikely that you'll ever see those profit margins increase very much.  People shop at Amazon because of the great deals.  Amazon Prime is one of the best deals going.  While not their closest competitor, Walmart (NYSE: WMT) also has low margins.  If Amazon increases their prices too much, they may loose some of their customer base to Walmart in areas where their merchandise overlaps.  I don't think that is something that Amazon is willing to let happen.

So, if Amazon can't fix their profit margin, what about growing revenue?  This, as the chart at the beginning of the article demonstrated, is something that Amazon is good at.  I have no reason to doubt that Amazon will continue to do this.

Ecommerce is still growing.  Some estimates project total ecommerce at $1 trillion by 2016.  A Morgan Stanley analyst says that Amazon's share of that pie will be 23.5%, or $166 billion.  Assuming that Amazon had around $60 billion in net sales for 2012, this would represent a near triple for business in just four years.  But hang on there before you go buying up all the shares you can.

Let's assume that my (admitted) assumption indeed holds true.  Profit margins will not increase substantially. What would that mean for the price to earnings ratio for the company in 2016?  Let's give Amazon a profit margin of 2% (That's actually a little higher than their average.)  That would give them a profit of $3.3 billion.  At the current market cap, that means they would have a price to earnings ratio of 37.4.

A p/e ratio of 37 is still a little higher than I like in an investment.  And remember, that number assumes that the business nearly triples, margins improve, and stock price goes nowhere.  

The more likely scenario

In my mind, the likelihood that the stock market allows this company to maintain this outrageous p/e ratio is slim to none.  The more likely scenario in my mind is that the share price takes a hit.  Even if this stock tanked 50% today, the forward p/e would still be over twice that of the competitors I listed.

Again, remember that I'm not saying that Amazon is going to goof up and be punished by the market.  On the contrary, if eager estimates have this company tripling revenue in four years, even conservative estimates should see a double coming.  This company has got everything going on: except net income.  Amazon's stock can't ignore their price to earnings ratio forever.

The alternative

Even if the share price never takes a hit, I see little upside for investors at this point.  As I've attempted to show, this company could nearly triple their business and still seem a bit pricey at the current value.  That being the case, why would we risk an investment in Amazon, when we can have some better options such as eBay and Mercadolibre?

<img src="" />

data by YCharts

While Amazon has struggled with net income, both eBay and Mercadolibre have grown net income over 100% a year over the past five years.  Mercadolibre is strategically positioned to take advantage of emerging markets in South America.  eBay meanwhile continues to push Paypal forward as one of their main drivers of growth.  Both have a lot of upside and potential from current prices.

I'll keep shopping at for the foreseeable future.  But I'll be staying far far away from their stock. 

thequast has no position in any stocks mentioned. The Motley Fool recommends, eBay, and MercadoLibre. The Motley Fool owns shares of, eBay, and MercadoLibre. 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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