You’ll have heard it said, and accepted it wordlessly.
“Lockdown must have been a great boost for Amazon.”
And what is there to contest? Everyone is shopping more online. Their little brown boxes are everywhere.
Just read the news – its sales are up plenty.
Amazon doesn’t have a monopoly on online shopping.
In fact, its 42% share of all goods sold online in the US actually fell during lockdown, to 34%.
Increased sales were counterbalanced by plunging profits, as costs soared (new staff) and margins fell.
Amazon has been on an incredible ride.
Higher and higher it’s gone. But these things always feel the force of gravity eventually.
Here’s a chart of Amazon’s share price between 1997 and 2003. A six-year period in which no progress was made, but the stock touched a 2,000% gain in the interim.
Zoom out though, and it looks like a brave ant standing next to an elephant. I’ve circled the six-year period in case it wasn’t clear.
Just since the lows of 2008, Amazon’s share price has climbed over 5,000%. The S&P 500, often declared to be way beyond the realms of normality, has risen 270% in the same time period.
Amazon trades on sales growth above all, which is why it has surged since coronavirus. Sales have indeed grown.
But sadly, not all sales are born equal.
During the crisis, Amazon focused on “essential goods” and efficient delivery for reputational reasons, and this meant higher costs of delivery and lower margins on the products, as essential goods tend to be cheaper and less profitable.
That’s why it grew sales well and profits still fell sharply. That and the 175,000 new staff it took on. But as I say, it’s growth which counts when looking at Amazon. So, let’s look a bit closer.
Here’s a chart of its share price (top), price-to-sales (middle), and price-to-earnings (bottom).
Since the virus, its price-to-sales (P/S) ratio has risen to 4.9x – ie, the price per share is 4.9 times more than the amount of sales revenue per share. This isn’t that out of the ordinary.
But given than Amazon’s is not a high-margin business overall, that leaves it with a price-to-earnings (P/E) ratio of 138x. Which is nausea-inducing.
The S&P 500 currently has an average P/E ratio in the low 20s. Apple has a higher P/S ratio actually – 6x, but a P/E ratio of only 30x, less than a third of Amazon’s. Facebook has a P/S ratio of 9x, but a P/E ratio of 32x.
The last time Amazon had a P/S ratio this high was at the peak of a rally in 2004, and before that, in the 1999-2001 period shown earlier.
If investors start focusing on things Russell Napier looks at (P/E ratio, q ratio), things look terrible for Amazon.
Napier’s four bear markets ended with P/E ratios averaging around 8-12x.
Such a fall would leave Amazon more than 90% below its current price, and that’s assuming that its earnings don’t fall in the process.
If earnings fall too, in a traditional recession-led bear market, and value investing takes over, things look even worse. A smaller fall – only to the market average P/E ratio of 25x with a 20% decline in earnings – would still mean a 90% price decline.
So you get it, Amazon looks expensive on some metrics.
But what other ways can be used to assess its immense investor support?
Jim Slater’s book The Zulu Principle advocates using PEG, or price-to-earnings growth. This allows you to measure a share price not against a fixed point in time, but against its rate of growth.
This makes sense. Companies are growing faster deserve and receive higher P/E ratios, high valuations. That seems fair, and so the PEG ratio is a way of measuring share price against the growth rate.
For Amazon, its PEG ratio (share price divided by average annual growth rate) is around 3.0x. This is not in any way an outlier if you look at its five-year range, shown below. That’s because Amazon’s earning growth is (finally) impressive in recent years, growing from a $240 million loss in 2014 to a $10 billion gain in 2019. Revenues went from $89 billion to $230 billion in the same period.
Quite honestly, it’s hard not to look at its recent financial history and get a bit excited by the rates and consistency of its growth. But we must not get carried away.
I mentioned earlier that Amazon’s share price had returned around 5,500% since 2007. The thing is, revenue per share has grown from around 45 to 600, itself a 1,300% gain, so in terms of valuation on a P/S basis, Amazon has only multiplied by 4x.
This goes back to Napier’s point about there being two kinds of bear markets. Ones with steep price declines, and ones where prices are broadly flat while earnings grow each year. Both represent decreases in value.
It’s the same with a company, so what we can see is that on a P/S basis, Amazon’s great run since 2007 has been based on two things.
A business expansion of roughly 13x, and a multiple expansion of roughly 4x.
It’s not just the madness of growth investors, or a crazy speculative bubble. All huge bull markets or bubbles are based on some powerful original truth, in this case that Amazon really is an incredible company. This makes it harder to judge – we can’t just cry bubble and wait to be proven right. Brilliant investors the world over continue to pile in, don’t forget.
It’s when you combine the two together – growth and multiple expansion – that you get the 5,000% returns we’ve seen with Amazon.
But can it continue?
The entire premise of this incredible valuation is that Amazon has a range of insurmountable competitive advantages.
For its valuation to fail, so must that idea.
Is that possible?
Well let’s look at some of the challenges to Amazon from an investment perspective.
These are, in short, abuse of 3rd party data for its own gain, increased competition through other e-commerce platforms and businesses’ own online improvements, social and political opposition and regulation, workers’ rights, conditions and unions, failure in China, a concentration of financial performance in a single division (AWS – Amazon Web Services), and finally, key-man risk, or the risk that Jeff Bezos might not in fact be a god amongst men. Also, I’ll offer one personal anecdote, which I imagine won’t be the first or last you hear.
I will delve further into these next time, have a good one until then.
Editor, Southbank Investment Research