Saturday, December 17, 2011

Do markets punish long term thinking? Amazon as a case study

This morning's New York Times has an article from one my favorite business writers, James Stewart, on Amazon. His focus, largely admiring, is on the fact that Amazon has made decisions that hurt it in the short term but create value in the long term. To provide at least two examples, he talks about Amazon's decisions to cut prices on products and go for a larger market share and to invest in in the Kindle, their book reader. The tenor of the article is that the market has short sightedly punished the company for its long term focus. Stewart uses one piece of anecdotal evidence to back up his claim that markets are short term: the stock price reaction to the earnings report on October 25, when Amazon announced earnings and revenues that were largely as expected but announced that it had been spending a great deal more than investors thought it had to deliver that growth.

I am no knee jerk defender of financial markets and accept the fact that markets not only make mistakes in assessing value, but also that a subset of investors are short term and over react to earnings announcements. In fact, I am sure that there are companies that you can point to that have been unfairly treated by markets for their long term focus (and other companies that have been unfairly rewarded for delivering short term results at the expense of long term value). I just don't think Amazon is the example I would use to bring this point on. Let's start with some general facts. Here is how the market has and is continuing to punish Amazon for its long term focus.
  • In the last decade, Amazon has seen its market capitalization increase from $4.55 billion in 2001 to $82 billion in 2011; the market cap for Amazon at the peak of the dot com boom was only $30 billion. An investor who bought Amazon stock in 2001 would have generated a cumulated return of 1300% over the last 10 years. 
  • In November 2011, after the earnings report that Mr. Stewart alludes to, Amazon was trading at 96 times trailing earnings and at two times trailing revenues. In contrast, the median PE ratio for a retail firm was about 15 and the median EV to revenue multiples was 0.8. By my estimate, Amazon is one of the most richly priced large retailers in the world.
  • Over the last decade, the firm has made multiple bets on growth and asked the market to trust it to make the right judgments. For the most part, its actions have been welcomed by markets that have been willing to look past disappointing earnings reports at the future. Jeff Bezos is celebrated as a great CEO, with comparisons made to Steve Jobs.
So, why was the market reaction to Amazon's last earnings report so brutal? As someone who has valued Amazon almost every year since 1998, I think I can provide some historical perspective. Amazon has been, at alternate times, revered and reviled by financial markets. In January 2000, at the peak of the dot com boom, based on my estimate of value for Amazon at the time, it was over valued by about 60%. A year later, based again on my assessment of value, it was under valued by about 50%. During the 12 years that I have valued the company, it has been overvalued in 7 of the years and under valued in 5 of those years. Since the beginning of 2009, notwithstanding the reaction to the last earnings report, investors have been on their manic phase with Amazon, pushing the stock price up more than 300% (from $54 to over $200). At its price of almost $200/share, just before its October earnings report, Amazon was valued to perfection and beyond. In fact, for it to be worth $200/share, it would have to deliver about increase revenues to more than $200 billion in ten years, while increasing its pre-tax operating margin from 2.5% to 4%, while generating a return on capital of 70%+ on its new investments. If you disagree on these assumptions, feel free to change them for yourself in the attached spreadsheet.

It is the last item that I would draw your attention to, because the last earnings report was a sobering reminder that while Amazon will continue to grow, the growth is not going to be easy or cheap. In my view, the market is still much too optimistic about the quality of Amazon's growth going forward and I think it remains over priced. In Mr. Stewart's world, that would make me a short term investor, but not in mine. At the risk of repeating a theme that has run through my posts for the last few months, growth has value only if it is delivered at a reasonable cost and a growth stock is cheap only if the market price reflects that cost. Amazon does not look cheap to me, even with a great CEO and a long term focus!


Kyith said...

hi there, perhaps you should start considering using google spreadsheet. it will help to spread your ideas much easier

Dave said...

I had a couple questions regarding the numbers in the spreadsheet. Firstly, in DCFValuation you add 4.5% to the riskfree rate in cell b15. Where did this number come from?
Secondly, why is the reinvestment not subtracted from year 0 (cell b7), using the amount reinvested from last year as the base from which to add? It seems like it would be accurate to do this, because as it is, the year 1 fcff is less than year 0.
Also, what were your inputs to compute the cost of capital in the input sheet?

Aswath Damodaran said...

The 4.5% is roughly what a mature company's cost of capital exceeded the risk free rate in 2011. In this spreadsheet, I don't allow for specific inputs for the cost of capital but if you want a more complete spreadsheet, you can download the fcffginzu.xls spreadsheet on my website.

Anonymous said...

Agree that Amazon does not look cheap. The effective rate of growth in market capitalization of 33% per year ($4.55 billion in 2001 to $82 billion in 2011) is about 3.3x the growth in earnings for the same period (if my calculation is correct). Do you think one of the main reasons -besides costs- why most active managers underperform the averages is because of the unsuccessful attempts to guess the timing and length of reversion to the mean ? Thank you.

Ray Kumar said...

Yes, a 90+ leading and trailing PE being given to Amazon already reflects pollyannish conviction of a cornucopia of profits in the "long-term" already priced in.

And I can't pass up James Stewart's lament about Wall Street's seeming short-term bias without this rhetorical snarky Keynesian quote:
"In the long run, we are all dead."

Jason DaCruz said...

Amazon's margins have been shrinking for a while, but people simply assumed it could make up for it by increasing their volume of business. The newest shift to e-readers is somewhat of an admission that their old model can no longer keep that rate of growth.

I'd be really interested to know what the margins are on digital media for Amazon. Do you have any idea?

Aswath Damodaran said...

They break down revenues but not operating income for digital media, but they have been very open about the fact that the Kindle does not make them money right now but they hope it will in the future. In fact, that is the basis of the Stewart argument that they are long term thinkers... And the market is giving them credit for it. My question is: Are they getting too much credit?

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Its really a nice case study..Really you did a great and intresting study..From this we know so many things..

Anonymous said...

I am curious generally what you think of Steve Denning's writing [1] and proposals? More specifically do you think it helps to understand the case of Amazon's fluctuating valuation on the market?

[1] Steve Denning's recent article published by Forbes:

Aswath Damodaran said...

If Steve Denning actually knew what maximizing value was all about, I would react. I think he misunderstands the concept and mixes it up with maximizing stock prices, which he then confounds with analyst expectations. The only thing radical about his ideas is their sheer confusion.

Mike said...


Mike said...


In this world, for the super-majority of the investors, maximizing the firm value and maximizing the stock-price are synonymous. You might be one of the few exceptions. Are you?

What is the reason you invest? To fund your retirement, children's education? OR just to feel good about the value of a company and never cash out?

The said article was proposing to change the incentive structure for the management. ( ie, structure of stock options, bonus etc).

Aswath Damodaran said...

I have always believed that managers who focus on maximizing stock prices and spend immense amounts of time in the feed and caring of analysts (who they believe will help them accomplish this) are misguided. Maximizing value is much tougher to do and good managers recognize that it is hard work and has nothing to do with analysts. If Steve Denning has a problem with stock price maximization, I understand. But his article specifically focuses on value maximization as if it were interchangeable and it is not.

Rohan said...

Hi Professor,

It appears that in your model you assume Amazon to remain a retail company for the next 10 years.

But with AWS becoming a prominent part of Amazon's strategy, don't you expect the SaaS business segment bringing in a higher % of revenues. If this does happen, the margins would be much more than 4-5%.

What do you think ?

Anonymous said...

How did you get Amazon cost of capital of 8%? How did you calculate it? And why is sometimes as a cost of capital used WACC, and sometime it's just some so-called riskfree rate like goverment bonds? And why your WACC is changing every year? Why some calculations have always the same WACC( it's not changing like yours).

I'm watching your valuation and corporate finance lectures( i'm little bit behind).

mensajes movistar said...

To @anonymous last comment , I don't really know.

Steven said...

Stocks are affected by many aspects and this could be one of them. Everyone is looking to get rich quick so stocks that has stable but very slow growth are not attractive for many investors so there is no demand and stock price goes down.
This is only one theory, but could be inaccurate for many other cases.

Subu said...

any updates professor ? Is it time for the "AMZN valuation for year 2012" ? ! :-)

thanks in advance

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Anonymous said...

Thanks for the wonderful post, only one doubt:

"A growth stock is cheap only if the market price reflects that cost"

Can anyone help me in deciphering the above insight?