Amazon: Don't Play the Losers' Game

April 25 2014

Recently, I’ve come across a piece about Amazon written by a prize-winning asset manager. After a painstaking sales pitch, she cites analysts’ expectations and adds that “Amazon will triple its earnings in 2014 and then double them again in 2015”. “Investors should not look at the insanely high price / earnings ratio”, she assures readers. When I saw the disclai

Amazon: Don't Play the Losers' Game

Recently, I’ve come across a piece about Amazon written by a prize-winning asset manager. After a painstaking sales pitch, she cites analysts’ expectations and adds that “Amazon will triple its earnings in 2014 and then double them again in 2015”. “Investors should not look at the insanely high price / earnings ratio”, she assures readers. When I saw the disclaimer which revealed she didn’t actually had any position in Amazon herself, I was quickly reminded of the “skin in the game”-principle of Nassim Taleb: be wary, investors.

Nothing Ever Changes

It’s always the same with stock bubbles — traditional valuation methods are being discarded and the greater fool theory is brought into play. It happened during the dotcom bubble of 2000, during the subprime crisis of 2007, and again today with dotcom 2.0. It will, as always, end badly for those buying at times they shouldn’t buy, even when tech shares have retracted somewhat from their record highs.

Amazon’s Immense Overvaluation

So what about that insanely high price / earnings ratio? The P/E of Amazon has indeed reached ridiculous levels: it’s now hovering around 550 times earnings. Even if earnings triple in 2014 and then double again in 2015, P/E would still equal 80 (!). Of course, P/E could be high because earnings are at a cyclical low. Yet the very opposite is the case: corporate earnings in the US are at record highs.

I do contend that P/E ratios are not the most appropriate way to value stocks, but the thing is: the case for Amazon gets even worse if we look at cash flows. Walmart currently generates free cash flow of about 4% relative to its enterprise value, whereas Amazon would need to generate over US$16 billion per year in free cash flow in a decade time just to match Walmart. Yet from 2001 to 2012 (in eleven years time), Amazon generated a meager US$12 billion of free cash flow.

Moreover, Amazon’s ROIC (return on invested capital) is terrible: a paltry 4%. Its return on equity equals a mere 3.06%, compared to over 20% by Walmart.

Amazon is priced for perfection and we don’t live in a perfect world.

Sales Pitch or Dilligent Valuation?

No word about the fact that Amazon will start paying VAT in various states in the U.S. (a study found that in states that already implemented a sales tax Amazon-purchases dropped 9.5%). Not a word about Amazon raising prices and delivery costs (without slowing revenue growth, supposedly). Nor about how Amazon treats its shareholders by not sharing important information and the consistent dilution of shareholder capital through generous employee stock options.

Investors that only look at the value of the underlying company but not to the price they pay are making a big mistake. But sure, please ignore any valuation: finding a greater fool it is. At current levels, Amazon is a losers’ game.

Tech Stocks or Something Different?

An intelligent investor stays far away from tech stocks for the moment. When priced for perfection, little upside remains and risk of principal loss increases.

Another asset also appears to be priced for perfection at the moment, albeit in another sense. Gold prices have corrected downwards to levels seen four years ago, all under the premise that economies are really recovering and that the extremely high debt levels around the world somehow don’t matter. A savvy investor, therefore, moves some of his funds into gold, not into tech-stocks and certainly not into Amazon.

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