Amazon.com, Inc. (AMZN) is one of the most valuable megacap companies on the Nasdaq exchange. The firm commands a high premium valuation because of its demonstrated record of consistent sales growth. However, it almost always appears grossly overvalued when using earnings-based valuation methods.

Amazon pursued a strategy of reinvesting most of its profits into the business. This strategy allowed the company to expand faster, and it also minimized taxes. As a result, traditional measurements of value often fail when applied to Amazon. Thus, several valuation metrics deserve close examination to accurately gauge the difference between market valuation and Amazon's business fundamentals.

KEY TAKEAWAYS

  • Traditional measurements of value often fail when applied to Amazon.
  • The sales growth rate is a better guide to Amazon's corporate health, with 30% per year being typical.
  • The operating profit margin at Amazon went up substantially between 2014 and 2019.
  • Amazon's high price-to-earnings ratio does not mean the stock is going to crash, but it does make shares more volatile.

Sales Growth Rate

According to the company's annual report, Amazon's yearly sales growth rate was 31% in 2018. This figure is near the recent average of 30%. The company continues to make many capital investments each year, mostly using cash flow from operations. That leaves little cash for anything else, and all eyes are on growth. Besides being at the forefront of ecommerce retailing, Amazon also runs a publishing platform for authors and publishers. The company takes a sales cut from every book it helps to sell. The firm began as an online bookseller, and Amazon is still growing its book business.

However, Amazon Web Services (AWS) is an increasingly important business for Amazon. AWS is an Internet cloud infrastructure built by Amazon. Developers and enterprises can run their online operations on Amazon Web Services for a monthly fee. Amazon's experience running one of the top sites on the Internet allowed it to start AWS long before most competitors arrived. AWS is actually the fastest-growing source of revenue for Amazon, and sales grew 47% in 2018. Given the continued transition to cloud computing, AWS appears to have strong growth prospects for the foreseeable future.

Amazon Web Services is actually the fastest-growing source of revenue for Amazon, and sales grew 47% in 2018.

Profit Margin

Most companies focus on their bottom-line earnings and profits. At Amazon, it was all about the top-line revenue story. The company believes that by increasing market share, it can eventually leverage economies of scale to lower cost. Once it has a high market share, Amazon can also exercise some pricing power over customers. Critics claim that the company must eventually start showing more profits and eventually pay dividends. Amazon may not be able to sustain its sales exuberance forever.

Amazon's operating profit margin hit 7.4% in the first quarter of 2019. That is the highest number for the company in over ten years. As recently as 2014, Amazon's operating margin was actually negative. Part of the increase in the operating margin is due to the rapid growth of Amazon Web Services. Web services are generally a much higher margin business than retail, so we might expect higher profit margins going forward. The other explanation is that Amazon is running out of areas to reinvest profits.

Traditional Valuation Metrics

Because the market has been valuing Amazon stock solely on its growth potential, conventional valuation metrics for Amazon often look absurdly high. The company's price-to-earnings ratio was 80.38 in November 2019. As a standard of comparison, Apple (AAPL) had a price-to-earnings ratio of 21.58. Amazon's high price-to-earnings ratio does not mean the stock is going to crash, but it does make shares more volatile.