Valuation: A Look At Free Cash Flow And Expenses

0 Valuation: A Look At Free Cash Flow And Expenses
By Szk7788 (Own work) [CC BY-SA 3.0 or GFDL], via Wikimedia Commons

Many people are amazed at the valuation of, 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,, 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. Valuation: A Look At Free Cash Flow And Expenses

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, 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

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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