Amazon was founded by Jeff Bezos and listed on the Nasdaq in March 1997 at $18 per share. At the time its principal business was an online book store. Its pursuit of growth over profit was met with some scepticism in the early years and not without good reason as it wasn’t until 2001 before it became profitable. Since then the company has dramatically expanded its operations to be the world’s largest e-commerce company as well as the global leader in cloud services and infrastructure (Amazon Web Services), payments and data storage.
Amazon has built a platform on a low cost advantage that has helped it build enormous scale and is now reaping the rewards with strong growth across most of its major segments. Although the stock always screens as expensive based on conventional multiples, it’s growth continues to exceed expectations and may well become even more dominant in the post-COVID world as the move to online services accelerates.
Despite its phenomenal success, it has always presented a conundrum for investors due to the eye-wateringly high price investors have had to pay. Unlike most listed stocks that might trade on a multiple of between 15 and 25 times forecast earnings, Amazon has consistently traded between 70-100 times earnings, or more. When compared against other investments, it has taken a leap of faith that the company will continue to grow at incredibly high rates to justify the huge upfront premium. Yet time after time, the company has managed to meet, or exceed, market expectations which has sent its stock price soaring above US$2,400 per share.
On 30 April Amazon reported first quarter revenue of $75.5 billion (ahead of market expectations) and net income of $2.5 billion (below expectations). What was really interesting however was that Bezos announced that most of the expected profit in Q2 would be wiped out by spending $4 billion on ‘coronavirus related costs’.
At first glance this seemed like bad news for investors. A company that has been used to spending money to build scale and further growth, now forced to change tack and spend money to keep employees safe, without any obvious addition to the bottom line. Yet company disclosures reveal a far more complex and nuanced story. The coronavirus pandemic had created unprecedented demand for Amazon’s online services, but it was completely unprepared for the surge and was unable to fulfil orders for numerous reasons. First, supply of high demand items such as food, masks and sanitiser was no longer available. Second, border and factory closures impacted supply. Third, the company was experiencing staff shortages exacerbated by the spread of the virus. Some were staying home for fear of falling ill and others staged walkouts.
In response to the challenges the company has hired 175,000 additional workers since March, increased its supply of Personal Protective Equipment (PPE), including 100 million face masks, 1,000 thermal cameras and 31,000 thermometers to improve safety conditions and is working to expand its systems including food delivery and pick-up services. In other words, apart from the procurement of PPE, Amazon is spending money because demand is stronger than ever and it is doing everything it can to ensure it can fulfil that demand. Further, the explosive growth in Amazon Web Services continues unchecked.
|Amazon Web Services||Q2 2019||Q32019||Q4 2019||Q12020|
You will see from the table below that Amazon is currently trading on a multiple of 122 times expected FY20 earnings.
|Share price 28/5/20: US$2,403||FY20||FY21||FY22|
|Earnings Per Share (US$)||19.75||38.35||58.33|
|PE on actual||121.7||62.7||41.2|
|Price to book value||14.6||10.9||8.29|
As the market average multiple for the S&P500 is roughly 16.5 times earnings and for growth stocks typically around 20-30x earnings, you can start to get an idea of how elevated Amazon’s share price really is. As the rate of growth typically slows as companies reach maturity, at some stage in future Amazon will most likely be subject to a much lower earnings multiple. On the assumption that a more normalised long run multiple will eventually be closer to 30 times earnings, we estimate that Amazon must grow its earnings by 305% on FY20 to justify its current share price.
|Current share price||US$2,403|
|Minimum future EPS required to justify share price||$80.10 (i.e. $2,403/30)|
|EPS expected FY20:||US$19.75|
|Future EPS growth required||305%|
A stock price is supposed to represent the present value of its expected future earnings. In reality it is very difficult to predict future earnings, which is why forecasting more than a few years out is fraught with a high margin of error. In Amazon’s case, if it is unlikely to grow its earnings by 305% then the current share price is not justified. If it can grow its earnings by this amount, or more, then the stock represents value at current levels.
Based on consensus estimates for the next two calendar years, Amazon is already expected to almost triple its earnings by the end of 2022. If this occurs Amazon then only needs to grow its earnings by a further 37% on FY22 expectations.
|FY22 EPS (US$)||$58.33|
|Required EPS (Equals)||$80.10|
Given its track record to date, this could possibly be achieved as early as 2024.
Amazon is a global e-commerce and cloud services behemoth. Despite screening as expensive on conventional valuation metrics, we think the company is in a dominant position to continue to benefit from the accelerated shift to online shopping as well as the surging demand for cloud based infrastructure and services. Any further correction on global markets may provide an attractive entry point into an outstanding company. This is general advice only and should not be interpreted as a recommendation as it doesn’t take into account individual circumstances, risks or objectives. Please contact your adviser to discuss potential suitability.