Many people are amazed at the valuation of Amazon.com, Inc. (NASDAQ:AMZN). How can a company receive such a high valuation when it earns so little money? And how can it grow so fast?
The second question is easier. They are reinvesting their free cash flow, which is different than profits. You can only reinvest excess (free) cash. Profits do not measure what you can reinvest, because profits do not represent change in unencumbered cash received.
In the past Amazon grew off of its free cash flows. In the last year, they needed to borrow $3.2 billion. Truth, Amazon.com, Inc. (NASDAQ:AMZN)’s balance sheet is not all that strong — a lot depends on the value of their intangibles. Their brand is so strong, the intangibles have value. The question is how much.
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We could figure out the value of the intangibles if Amazon raised its prices a touch, and saw how much free cash flow increased, and market share decreased.
One person asked me whether Amazon becoming subject to state sales taxes would be a good test of the franchise, even though Amazon receives none of the proceeds. I replied,
“That could be a good test. Not sure $AMZN will share that data with us, but that would be a good thing to analyze. Doesn’t matter that the money doesn’t go to Amazon — it will show how sensitive demand is to price changes. Then Amazon could get an idea of what an additional price change would do for them.
But maybe it is Amazon’s strategy to chase out all competitors now, and wait for the payoff day to come. That said, especially on the internet, competitive advantages are hard to sustain. People adjust rapidly to changing incentives.”
That brings me back to the first question: How does Amazon get such a high valuation? Think back to the cable company stocks, which plowed all of their debt and free cash flow into growth. They had little if any taxable income. They acted like private equity companies, but were publicly traded. That is how Amazon is acting now, and so people are valuing it on the hope that when is gets to maturity, it will be an actual near-monopoly, having a lot of power to raise margins with impunity.
I should mention that this is a dangerous strategy, particularly with an internet company, because the costs of switching are low for customers. Can Amazon make itself so irreplaceable that a future Amazon will have little difficulty passing through price increases?
As for current Free Cash Flow, Amazon does not help — they do not split out maintenance capital expense. (Hey, let FASB justify its existence and require that maintenance capital expenditure be a separate line item.)
But imagine for a moment that Amazon.com, Inc. (NASDAQ:AMZN)’s operating cash flow is the free cash flow. No maintenance capital expenditure. Should Amazon trade at a 30+ multiple of free cash flow?
No. And that is a biased measure, because maintenance capex is not considered. I expect there to be a correction in he stock price of Amazon, unless it moves to increase its gross margins. If it can’t do it, it will not prosper. Good company management aims for free cash flow. It does not aim for big returns far in the future. The future is far more variable than most believe, so intelligent businessmen give light weight to the far future, because their view of what might happen is unlikely.
By David Merkel, CFA of Aleph Blog