Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

In November of 2004 I wrote a piece entitled “Sleepless in Seattle” which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock’s performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock’s valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer Amazon.com (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $7 today to $57 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon’s growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon’s growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today’s quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon’s business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon’s stock.

It seems that argument has not been realized. Amazon’s operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon’s margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy’s (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Full Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

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8 Thoughts on “Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

  1. Nice analysis.

  2. Unfortunatley, not many “average” investors have the ability to do this type of analysis. They hear news reports that Amazon actually made a profit while most companies are taking losses and slashing jobs so they figure Amazon is a good investment.

  3. Parkite on January 31, 2009 at 11:19 PM said:

    If it is so overvalued, why aren’t you short? Or at least long puts? Especially given your prescience with Starbucks. I think you analysis makes sense and you likely will be correct. Why not make money from your insight?

  4. Chad Brand on February 1, 2009 at 12:46 PM said:

    Parkite,
    One of the many reasons I started this blog was to highlight investment ideas that I uncovered but did not have room for in my personal accounts or those of my clients. I run very concentrated portfolios (typically no more than 30 positions on average), so I can’t act on every investment idea I have. If I write about them, however, at least others can. Re: AMZN if I had room to play it, my trade would be to short AMZN and pair it with a long, either a retail index or the S&P 500.

  5. I did the same analysis for RIMM in 2004 when the stock was trading at 50x PE. Unfortunately the stock went up 10x after that. I agree with you that Amazon will get killed eventually because of the retail environment we are in.

    When does it make sense to buy a high PE stock?

  6. Chad Brand on February 2, 2009 at 9:13 AM said:

    High P/E stocks as a group lag the overall market by a huge mount over the long term. However, that does not mean every high P/E stock does poorly. There are a few exceptions, those companies whose market has so much upside that they actually deliver on the huge growth potential without making any mistakes. RIMM five years ago fits that mold, as you point out.

  7. Parkite on February 6, 2009 at 2:02 PM said:

    Don’t look now, but it is over $66.

  8. anonymous on February 13, 2009 at 8:44 PM said:

    Calling Amazon a retailer is like calling Berkshire Hathaway an insurance company. It’s a core business, and the source of much of their cash flow, but it doesn’t define what they are.

    Their long-term future is to be classified as a utility, an owner and operator of key infrastructure, a platform provider. Cloud computing is likely to be part of that.

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