Warning, this is a long hard-core finance article. It’s mostly about the valuation of Amazon. The stock is so expensive, I can’t even… My blue sky scenario is -90%.
March 2000 was a good year for drunks…
I’ll show with a few simple assumptions and calculations why I think Amazon’s shares are 10-20 times as expensive as I would find attractive.
I’m not advocating going short the stock though. You have to realize when you don’t “get it”. At this point I’m not quite sure what would change my mind about this. It’s just so far off from what I consider reasonable that the situation simply is out of control. Hence, better not risk any money.
All I really do in this article is extrapolate growth and margin trends, and then state what kind of return I demand from an investment to consider it worthwhile.
You are free to have different preferences or assume others (i.e. the market) have.
Read on if you are interested in a step by step pedagogical approach to back of the envelope investing
Beer or IT stocks?
At the height of the stock market bubble in March 2000, you would have been as well off financially if you bought beer and recycled the cans (in certain states), than if you “invested” the money in many IT shares.
As it were, the entire Nasdaq index (not only tech stocks) declined by 80 percent, and many stocks declined by much more. Just cash would of course have been so much better than beer, not to mention bonds or gold.
The difference between an 80% drop and a a 90% drop is an additional fall by 50% in value.
And yet another 50% loss takes the total loss to 95%. A third sequential 50% loss, after the initial hypothetical 80% plunge, renders a total loss of 97.5%, which aptly describes the trajectory of many IT and new media stocks during the years 2000-2003.
Stars do fall; Nasdaq composite index 2002-2015
I should know, since I was chiefly (ir)responsible for buying shares in an internet consultancy called March 1st (named after its starting date March 1, 2000, at the very peak of the bubble). Luckily, we made back the initial losses on that position (and sold it before the bankruptcy in early 2001). We then went on to earn so much more shorting similar stocks in Europe, using the US stock market as a template.
Make informed investments, with whatever you have left after Mr Market taught you a lesson – always be investing
The IT crash was no surprise
To many thoughtful and experienced investors the crash of 2000-2003 didn’t come as a surprise. I have a list of 50 prominent investors and other pundits, that intelligently and timely forecast an epic bursting of the insane IT bubble. Many of those went on to correctly predict a housing crash and a financial crisis after 2006.
Neither of the last two crashes came as a surprise to anybody with the slightest knowledge of the art of valuation and the history of markets and bubbles. The timing, however, was often off by a year or two – or more.
Crash number 3 is in the cards
I think it’s about time again for a correction of frothy share prices. And by correction I mean on the order of -50%.
There are dozens, if not hundreds, of fingers pointing to that conclusion, but this is one of my favorites:
Dr John P Hussman’s chart over “Price/GDP” vs. stock market returns
Observe, e.g, where the blue line bottomed in 2000, correctly forecasting ten years of negative annual returns 2000-2010. Or peaked in 2009, forecasting 12% annual returns 2009-2019 (with the market so far well on its way to fulfill that prophecy).
- Notice the tight correlation
- Notice that when correlation falters for a while, it comes back with a vengeance. Actually this “error” in itself makes a better job predicting market returns than the revered “Fed model”
- Right now, market valuation points to negative annual total returns, including dividends, over the coming 10 years
- Usually the market corrects to levels where you can look forward to 10-20% annual returns over the coming 10 years. To get to that point the market needs to fall by 50-75% or stay level for 10-15 years. Which do you think is more likely?
- A vertical move upward by the blue line is tantamount to a stock market crash, thus changing the valuation from promising, e.g., 0% return to promising 10% annual returns the following decade.
Amazon – buy the merchandise not the shares
I have bought 2 Kindles from Amazon and hundreds of books. It’s a great company – for its clients.
However, let’s take a closer look at Amazon’s shares as opposed to their services. A quick visit to Market Watch tells you the stock price is 528 USD/share, with a total market cap of 251 bn USD.
There is no useful information on valuation, though, (since Amazon operates at a loss and doesn’t distribute dividends).
So, what do you do? Ask your friendly neighborhood hedgehog?
-No, you do the math yourself. If you consider yourself a real investor, that is. But first, let’s find out if you’re cut out for this. What kind of money person are you?
Amazon’s share price 2002-2015
N.B. Amazon’s stock price has already fallen by >50% twice, and by >30% several times
Astute Investor or Ignorant Speculator
- Active or Passive. A passive investor buys and holds single stocks or index instruments -and never sells. An active investor buys and sells at various intervals, depending on a multitude of factors (we’ll get to that later)
- Single stocks or index investing. If you chose index-only investing, forget about Amazon (duh!)
- Fundamental or Technical. Are you willing to make an effort to understand what you invest in, do the math so to speak, or are you more inclined to speculate on tips, momentum, stock charts etc?
- Hope or Safety. Will you trade on hype and hope, on blue sky scenarios, or do you have the discipline and patience to wait for opportunities that offer a margin of safety
If you are an active investor and single stocks focused you can proceed. If you are passive, just buy the stock or an index already and go back to sleep.
See. Pretty picture
If you just can’t be bothered with math, spread sheets, forecasts and economics, do what so many others do: draw pretty pictures in stock charts and invest according to the patterns you think you can discern.
Or just follow whatever momentum or trend you want to see or you are told (tipped) about by a “friend” or broker. Just don’t blame me when you go broke.
lines in a chart are not real
Your broker is your adversary
Stock brokers don’t want you to make good investments. They don’t want to be your friend.
They want you to pay a commission.
When you buy, somebody else sells. One of you is often making a mistake. And the broker couldn’t care less.
Charlatans (stock brokers and company representatives) use extremely simple and misleading measures of valuation such as some future year’s Price/Earnings ratio (given made-up profit margins), perhaps complementing it with an arbitrary, historical growth number.
“Amazon has increased its number of employees by 38 per cent in the last 4 quarters and at ‘normalized’ operating margins of 10% it’s trading at an EV/EBIT ratio of just 21.5 x (12 months forward op. earnings), i.e., only half its (employee) Growth rate! PEG=0.57 which is below 1, hence BUY!”
Assumptions: TTM sales of 95.8bn in June 2015 will grow at the same 17% rate the coming four quarters to 112.1bn. The operating profit at a 10% margin will be 11.2bn. The current EV is 251bn-10bn cash pile=241bn. The EV/EBIT thus comes to 241/11.2=21.5. The growth rate used in the PEG calculation is the last known employee growth rate.
Stock pitch break down
The above may sound convincing. But if you look more closely you’ll see the cracks in the facade:
- Okay, so the number of employees grew by 38%. Even if it could be representative of future growth in some cases, it’s also a cost now. Sales, however, only grew by 17% the last four quarters (despite a 36% growth inemployees in the preceding period), and slowing. Thus, a better forecast of sales growth going forward would be 15%, given current trends.
- In addition, the relevant growth rate, for applying a valuation multiple, is the growth rate going forward after the year of the multiple (which probably is even less, given the deceleration the last few years). Actually, unless profitability accelerates soon, Amazon needs to taper its hiring pace, which should hurt sales growth even more. Nevertheless, let’s give them the benefit of the doubt for now and assume 15% sales growth. We can refine the model later.
- “Normalized” profit margins at 10%? Whats “normal” with 10%, when actual margins have been between 0-1%? Are there any plausible reasons to forecast higher margins than what Amazon has produced the last 5 years?
- Actually, there might be. If Amazon reaches ‘scale’, when growth diminishes, margins could increase. This is the trickiest forecast of them all, since Amazon hasn’t reached “steady state” with sustainable growth and margins, so what to do?
- Look to similar companies for guidance on potential margins. Also make a sanity check on what ROE those margins imply for Amazon (Return On Equity). Few companies stray outside 5-20% ROE for long. A higher ROE draws in competitors, and a lower ROE is a waste of capital. Assuming Amazon can increase its net margin to 1.5% (operating mgn approx 2%), Amazon will make a decent 14% ROE (1.5%*112bn/11.768=14.3%). Hoping for more is just that; hoping and believing the hype.
- EV/EBIT-ratio of 21.5. Why is that supposed to be cheap in an absolute way? How can you tell? To start with it should be compared to profit or cash flow growth, which (at steady margins) can be approximated by sales growth – in our example at most 15% (probably less after 2016). Suddenly the PEG is 21.5/15=>1.43 instead of 0.56. That still doesn’t say anything about whether it’s a good buy or not, even if it can be compared to other listed companies’ PEG ratios. Anyhow, it’s apparently a lot more expensive than what the broker first said.
- And, I almost forgot, that was based on a 10% op. profit margin. Assuming 1.5% instead, renders an EV/EBIT of 143 and a PEG of 10. That is 19x expensive-er than the broker was saying.
- In addition, whatever happens in 2016 is less worth than if it were today, so profits should be discounted by your required rate of return. An EV/EBIT of 143 a year from now is some 5-10% more expensive than the same multiple today, or >150. That however still doesn’t answer the question whether Amazon’s stock is expensive. Do, however, compare the 150x on trailing EBIT to the more typical 10-20x multiple seen in the S&P 500 index. Enticed?
- Continuing to use the extreme simplifications above, you can calculate an earnings yield to see what your actual return would be in a single year. If you dare extrapolate that year indefinitely, you can even rely on it as the stock yield. In Amazon’s case, given 1.5% operating profit margin and a 30% tax rate the net profit is 112*0.015*0.7=1.18 bn and its earnings yield is (profit/market cap) 1.18/251 = 0.47%.
- If you are lucky all this profit generation is converted to cash and distributed to you in some way. Also, if you are lucky, the coming four quarters are representative of the coming eternity for Amazon’s business (in practice only about 50 years count).
There you have it. Given a set of simplifications, you can expect around 0.5% yield on an investment in Amazon. It doesn’t really say anything about what price you’ll be able to sell the stock for in the future, but if you just hold on to it forever, you’ll get an 0.5% annual return on your investment, unless Amazon’s business changes radically.
The quick and the dirty
Happy? I’m not. And that’s not because of the low return, or that the stock might (should) fall dramatically in the meantime (to a price where you could expect at least a 7% annual return). It’s because of all the simplifications.
Just because you put a lot of numbers down on paper doesn’t mean they are correct or you are any wiser
Also note that, if in the future, when you want or need to sell the stock to get your capital back, another valuation paradigm dominates, perhaps demanding the historical 6% or 10%, 15% or even 20% return on equity investments, the Amazon stock price will be proportionally lower.
At a 9% required return, Amazon’s stock price would be just a twentieth (27.50 USD/share) of what it is at 0.45% required return.
That was the quick and dirty way of analyzing and valuing single stocks. You should at least do as much for any stock you contemplate buying.
- Estimate (extrapolate) sales growth and margin trajectory in an informed manner
- Calculate future profits and cash flow that take into account total available market, innovation and competition
- What yield in relation to the company’s market cap does that cash flow produce?
- If you’re happy with that yield and don’t care if the stock falls in price, you’re good to go
- If the yield is below your required return (9% for example) or the historical market return (7%) and you do care about price fluctuations, tread carefully.
- Is that enough? Are there better alternatives? Is it enough for others (i.e., the market)?
Get out of here!
If you felt that was already too much, you are not an active or fundamental investor. A sell side analyst does a lot more. It’s not necessarily better or more effective but it’s impressive work.
The long winding road of doing sell side level research and stock analysis
Make company forecasts like a ‘pro’
- Make reasonably detailed Profit & Loss, Balance Sheet and Cash Flow forecasts. These are hundreds or thousands of Excel rows long, several hundred columns wide and dozens of sheets thick
- To do that you need to forecast sales, costs, wages, investments, loans, interests, taxes, dividends, buybacks etc
- Any one of those components can be forecast using a dozen other inputs
- To do that you need a view on demand, competition, currency (FX) trends/fluctuations, technological development etc.
- You also need the company’s history to have an inkling of how its products have been received by the market and how management has been able to juggle all variables historically.
- Total market valuation (if the stock market in general is “cheap” you stand a better chance the entire market will rise and help your shares appreciate. The latter, however, only really matters to a hedge fund and not for a long only index fund)
- Momentum in the stock or the market (positive market trends can lift all boats)
- Risk tolerance, i.e., your willingness to gamble (and willingness to lose)
Stock prices move in cycles. Sometimes a certain industry or company is in vogue and sometimes it’s not. You can try to speculate blindly with this momentum or you can choose to invest whenever the price (valuation) is below a certain maximum threshold and sell when it is too high for a comfortable plausible return. Dare to make your own judgement of value and buy when others don’t.
It’s better to look the fool before, than after an event
Analysts make meteorologists look good
There is no secret to forecasting. No one can do it anyway and stock market pundits and economist are among the worst forecasters of all.
I think my complete immersion in finance for a quarter century is why I have always marveled at the accuracy of weather forecasting (no irony, I am amazed of what they can do).
The following can serve as a rough guide to informed forecasting of financial data. But remember that your forecasts don’t become the truth just because you put them down on paper.
Collecting historical data
- Get at least five to ten years of history for a simple set of parameters for the P&L: sales, cost of goods, cost of personnel, cost of loans, taxes
- Make a rudimentary balance sheet: real Long-Term assets, goodwill and intangibles, Short-Term assets, cash, net working capital, equity
- Cash flows: operating profit after tax, investments, changes in Net Working Capital
- Double check for funnies: too low wages vs history or vs. competitors, high personnel option compensation, share count development; profit, cash flow and equity not adding up over the years etc. Make charts of every series and subseries you can think of an look for kinks, trends, holes, bumps and so on. Then investigate those by reading old Q-reports, ex ante guidance commentary and ex post explanations.
- Check the latest quarterly trends more carefully: DSOs, e.g., (Days Sales Outstanding=accounts receivable/sales) = how easy is it to get paid, is the company overselling or even sending unsolicited invoices?
- Find leading data series in daily, weekly, monthly or quarterly data: from competitors’ sales, costs etc, weather data, monthly national data, PMI surveys, national industrial output statistics, retail sales, FX, etc
- Start forecasting: Basically extrapolate trends in historical company numbers and leading data series. Allow for cyclicalities and reversions to the mean. E.g., profit margins and Return On Capital Employed numbers tend to gravitate to a mean for the industry or the economy. Do not expect super profitability or super growth for eternity. Check how long the very best companies of all time sustained their growth, margins or returns. Check what the average company did, including those that failed and are no longer here. Easiest is to check nation wide numbers for margin and growth trends.
- Analyze really long cycles (over several decades or longer) and trends to make sure you don’t get myopic, narrow sighted, seeing only one half of a cycle and thinking that is a long term trend to be extrapolated without risk
Knowing what you don’t know
All of this is particularly difficult for new companies and even more difficult if they operate in new industries. There is no history, no precedent. That doesn’t mean you get off more easily. Quite the opposite. The risk is higher and your work is harder.
Sell side analysts take advantage of the lack of data, and of the general optimism, to forecast blue sky scenarios, luring in buyers. Rising share prices then act as (false) evidence the forecasts are correct.
Don’t fall for the simple three letter abbreviation trickAsk and ask again until everything’s clear. Then make reasonable forecasts not based on 100% market share forever, constantly rising margins, and world domination of this industry and ten more nearby.Take a minute to remember all those formerly glorious companies that perished and disappeared in the 2001-2003 downturn, despite all the thre-letter combos in the world in their Power Point presentations.
Don’t forget geographical trends, product trends… to see if, e.g., the first markets, the home markets are losing steam, or perhaps if new markets are small but growing quickly – which might not be visible in overall numbers otherwise. Slice and dice numbers in all directions and look for S-curves, tapering, bumps and exceptions.
Typically it takes at least a few years to get reasonably good at doing fundamental research, and at least a week to build a basic valuation model for a single company. It’s hard work and it’s complicated but it’s worth it if you have a nest egg worth a handful of years’ income to invest.
Don’t supersize that model, please
Stock prices and stock markets very seldom reflect the true long term value. Just as a stopped clock shows the right time twice a day (in Europe, actually only once), the stock market is valued more or less correctly about every six years or so.
That’s a good thing. It’s something you can profit from; if you have the guts to take a contrarian view when everybody else is screaming sell or buy. Or the guts to run with the lemmings for a while longer, even after the fat lady has finished her aria.
Markets are not weighing machines, they are beauty contests (in the short to medium run). They don’t find the correct value of a stock and stay there. On the contrary, markets forces of fear and greed create trends where the (perceived) prettiest stock is bought and the ugliest sold, until something, anything, changes and the trend reverses.
- Buy whenever a stock or an index is reasonably valued, or cheap, even if the trend is negative. Keep buying small increments.
- Ride the momentum until it seems to stop (market dispersion crosses a threshold) or valuations venture too far out in the 5% tails
- Sell if it is extremely expensive, no matter the trend, but don’t go short until market dispersion tells you risk aversion is high enough.
Hype and Hope is not a strategy
Don’t rely on blue sky scenarios. Very few companies hit it big. Why would yours? Perhaps just because you are looking at it (quantum mechanical interpretation).
Remember that you are only looking at the winners when looking at the current stock market
Don’t just flip a coin and hope for the best. Do the only thing very few investors do.Pay attention to long term fundamentals, be patient and only buy when you have a decent safety margin, in terms of returns and think you can hold on forever and be pleased with that.Don’t run with the crowd, unless you know what you are doing.
- Don’t hope to sell the stock to a bigger fool
- Don’t hope for efficient markets having priced all shares correctly so you can just wander in and buy blindly
- Don’t hope that just any old stock will work as a hedge against inflation and money printing.
- Equity research is really easy and impossibly complicated at the same time. Just as life in general. Decide what type of effort you are willing to put in and what level of risk you accept. Just be explicit about it
- Decide what kind of an investor you are. Active? Fundamental? Single stocks or index? Technical overlay? Gambler? Act accordingly
- Do the math properly if you are going to do it at all. There is no big secret to forecasting; just do it, and be clear about your premises at all times. Make plausible and reasonable forecasts that are internally consistent. Double check your variables repeatedly. Believe the hype if you want; make a leap of faith in a product if you want, but make sure you understand that is what you are doing. Be explicit in your extreme assumptions.
- Cheap or not? Compared to what? To your required return? To your marginal borrowing costs (your most expensive loan if you have any), to what you think the market’s marginal required return is or will be in the future? Compared to other stocks? Here is an overview, a check list, for doing equity research.
- Decide on timing: It may be cheap, but markets are trending sharply downward. Then don’t buy until things calm down, or be prepared to ride a long downturn. Pace your purchases, buy a tenth at a time unless you have a specific game plan.
- Wait. Be patient. Don’t expect good opportunities just because you are looking right now. It may take years for real opportunities to arise, whether it is about stocks, finding a life partner or a dream job. It can take 20 years for fundamentals to manifest themselves (though 8 years usually is enough). If you bought on the right side of cheap, time will work for you. In the meanwhile you accumulate dividends and perhaps buy more shares.
My best guess is that Amazon’s sales growth will fall slightly each year from 17% to 15%, from 15% to 10%, and sooner or later from 10% to 8 to 5% (assuming around 5% nominal growth rate for the economy in general).
Just spending a few hours with Amazon’s numbers, I think it is 10-20x as expensive as it should be. The current growth rate is only 17% per year, despite expanding its staff by 38%, and the company is hardly making any profits.
Assuming a decent 15% ROE in the future implies 1.5-2% operating margins and not even a 0.5% earnings yield (net profit/market value).
I would require at least 10-20x that return, i.e. 5-10% annual return on my investment, to bet on Amazon succeeding in its endeavor to sell everything to everybody. Consequently, the stock price needs to fall by 90-95% to satisfy my return requirements.
In addition, I can’t see any reason to assume growth or margins expand meaningfully in the future. Rather, I am worried growth will taper faster than most expect and that margins might fall to zero or below. I know the market believes and assumes Amazon can raise its margins to 5-10% as soon as it wants to, as soon as it concludes its hypergrowth phase (17%, remember?). It’s just that you seldom see those margins in retail. Ask Wal-mart.
In my opinion the blue sky scenario is Amazon trading down by 90%. The base-line and worst case scenarios are that Amazon falls even more and becomes completely irrelevant and taken off the market.
So, what should you do? Well, not buy Amazon, that’s for sure.