Amazon is set to lose a major part of its price advantage with the addition of sales tax. This means that, since margins can’t really be suppressed further, Amazon’s prices will in general go up. This will cause revenue growth to slow. The question which remains is, when this happens, what useless metric will analysts cling to in order to justify their ridiculous price targets?
The reason why Amazon’s valuation is so insane is because it assumes that both revenue will continue to grow extremely quickly and that margins will improve. Let’s imagine a scenario where Amazon is able to grow revenue at, say, 25% for the next 10 years. At the same time, Amazon achieves Wal-Mart level operating margins of 6%. Clearly, both of these things cannot happen at the same time, but let’s try to value Amazon as if they could. EBIT would be about $3.6 billion this year, which would drop to about $2.5 billion after interest and taxes. If margins remain flat then this net income would rise by 25% annually with revenue.
Doing a simple discounted cash flow calculation using net income as the cash flow, a discount rate of 12%, and an after-ten-year growth rate of 3%, the hypothetical value of the company comes out to $133 billion. This is about 10% higher than the current market cap of $118 billion.
But this calculation assumes two conditions that are not compatible. If we assume high revenue growth then we cannot assume high margins, and vice versa. If we do the same calculation with, say, 10% revenue growth instead, the value of the company is just $46.5 billion. If instead we adjust the operating margin to 3% then the value of the company is $67.5 billion.
The Bottom Line
Amazon is a ridiculous stock. The numbers which matter for every other stock are, at least in the minds of analysts and some investors, irrelevant for Amazon. One of my favorite Warren Buffet quotes is:
“An investor needs to do very few things right as long as he or she avoids big mistakes.”
Amazon today is the mother of all big mistakes. It’s madness, plain and simple, which is driving the stock price up and up regardless of sensibility. Investors are basing their investment on two very big assumptions which, while on their own are quite a reach, together are utterly impossible. There is no reasonable justification for buying Amazon at today’s prices.
The article Amazon: When Will The Madness End? originally appeared on Fool.com and is written by Timothy Green.
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