Amazon Is Uninvestable
publication date: Aug 25, 2016
author/source: Brian Nelson, CFA
Image Source: Claudio Toledo
By Brian Nelson, CFA
Amazon is uninvestable – there we said it.
Let’s learn why though. We can’t make such a blanket statement without backing it up with some serious financial analysis and valuation logic. The following is for educational purposes only and represents an excerpt from Valuentum’s Financial Statement Analysis seminar. I say this because the models included in the below exercise are not our most recent ones of the respective companies. Those models are available on a per-request basis. So reach out to us!
Here’s what I want you to do:
2) View fair value estimate of $439 in cell B14 (note again that our fair value estimate has changed for Amazon subsequent to this exercise). If you’d like to receive fully-populated valuation models as part of your membership, please consider the Advisor membership.
3) Change cell L78 to 69% from 68%, to drive a one percentage point change in the mid-cycle operating margin assumption.
4) Go back to cell B14 to witness the change in the fair value estimate to $381 (a near $60 per share fair value change).
5) Because of Amazon’s large revenue base, small changes in profitability (the profit margin) can have huge changes in intrinsic value (we call this earnings leverage). Even minute changes to our forecasts for Amazon's profit margins can have massive implications on its fair value.
6) Now consider this: Do the same exercise, steps 1-4 above, for Microsoft (MSFT) in its financial model excel file here (xls); same cell references as the Amazon example. Our fair value estimate of Microsoft has also changed subsequent to this exercise.
7) Please note the sensitivity of Microsoft's fair value estimate (cell B14) to a one percentage point change in the mid-cycle operating margin assumption; it is much less severe one (a few dollars), effectively immaterial compared to Amazon’s.
The exercise above helps illustrate in part the value of the DCF (discounted cash flow) valuation model in uncovering key areas of sensitivity of the fair value estimate of each company in our coverage universe. While the one percentage point change in the mid-cycle operating margin assumption for Amazon, for example, resulted in a rather large change to the fair value estimate, a one percentage point change in the same mid-cycle profit measure for Microsoft on the other hand could be considered largely immaterial to its valuation, by comparison.
Estimating the mid-cycle operating margin assumption correctly for Amazon to the tenth of a point, for example, can in many ways become paramount to its long-term investment case, where on the other hand, the forecaster can be several percentage points off the mark or more for Microsoft and still be comfortable with the software giant's fair value range and investment opportunity. This is in part why we demand a large discount to our intrinsic value estimate in Amazon's case (due to the sensitivity of its key valuation drivers), but not as large a one for Microsoft as the latter's business and free cash flow stream is more predictable. From our perspective, nobody can pinpoint Amazon's mid-cycle operating margin to a sufficient approximation to deem shares under/overvalued with any sufficient degree of confidence. Amazon's earnings leverage, which cuts both ways, is far too great. This thought process is in part how we determine each company's fair value range.
If you haven’t already, please be sure to view each firm's fair value range in their 16-page reports on the website to get a feel for how we evaluate the impact of each company's fair value estimate to changes in key drivers in their respective financial models. Understanding which drivers companies are most sensitive to, through the lens of a DCF model (as the key drivers are often different for each company), helps us and investors of all types better understand the risks, uncertainties, and vulnerabilities of their stock investments. This is just one of the many, many benefits of DCF valuation analysis! I hope you enjoyed this exercise.
Please contact me at email@example.com with any questions.