Amazon.com, Inc. (NASDAQ: AMZN) is one of the most valuable, mega-cap companies on the NASDAQ exchange. The company commands a high premium valuation because of its demonstrated record of consistent sales growth. However, it probably would have been grossly undervalued when using normal, earnings-based valuation methods. Thus, several valuation metrics deserve close examination to properly gauge the difference between market valuation and Amazon's business fundamentals. In its business, the company sells everything at very competitive prices, leaving little room for profit margins.
Sales Growth Rate
Amazon's five-year sales growth rate is close to 30%, which is no mean feat especially for a company that has been growing throughout its corporate history. The company continues to make a lot of capital investments each year, using mostly cash flow from operations aided by a moderate amount of debt and leaving little cash for anything else with all eyes on growth. Besides being on the forefront of e-commerce retailing, Amazon also runs a publishing platform for authors and publishers where the company takes a sales cut from every book it helps sell. Originally starting as an online bookseller, Amazon has kept and augmented its book business tradition that still contributes to its sales growth as of November 2015.
What may be a lesser-known Amazon business to some is Amazon Web Services (AWS), an Internet cloud infrastructure built by Amazon and rented out to other developers and enterprises to run their online operations. Taking advantage of its Web operation experience and expertise as a leading online retailer, Amazon started AWS way ahead of its competitors including Microsoft's Azure. AWS is actually the fastest-growing source of revenue for Amazon and has seen a near 40% sales growth rate. Given the continued transition to cloud computing by businesses, AWS is in for a period of strong growth for the foreseeable future.
While most companies focus on their bottom-line earnings and profits, at Amazon it is 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, as well as exercise some pricing power over customers who have come to depend on Amazon. But such earnings-flowing days have got to arrive sooner rather than later for the company. Without making enough money to really grow shareholders' initial investments, Amazon may not be able to sustain its sales exuberance forever.
As of November 2015, Amazon's operating margin and net profit margin are a mere 1.71% and 0.35%, respectively. The company has even lost money in some quarters. Such anemic performance in profitability does not contribute much to the increase of shareholders' equity, which over time could lead to an even bigger discrepancy between market value and the company's actual book value, making its stock vulnerable to potential price volatility.
Because the market has been valuing Amazon stock solely on its growth potential, valuation numbers based on traditional valuation metrics including price-to-earnings (P/E) ratio and price-to-book (P/B) ratio all look in the stratosphere for Amazon. The company's P/E and P/B ratios are over 900 and 30 respectively, a real feat not present even for other more valuable companies such as Apple and Microsoft. On average, fairly valued companies most likely have P/E ratios in the mid-teens and P/B ratios in the low single digits.
The only way to get its high-flying valuation numbers under control is for Amazon to start increasing its earnings and expanding its equity base in the book. But that requires a change in business strategies, gradually shifting operations from sales-centric to earnings-focused. It would surely take a lot of earnings growth to level out the stock's current valuation if investors become more interested in future earnings stories.