What’s the similarity between Amazon and Berkshire Hathaway? Market Capitalization.
Amazon’s market cap is 350 billion now vs Berkshire’s 360 billion. Both are behemoth.
But, if we look at the revenue, profit, margin, ROE, Berkshire is far superior. Look at the charts below for comparison. The revenue and net profit are in milions USD.
From the revenue chart, you can see that Amazon’s revenue is trying to catch up with Berkshire’s over the past 10 years. Amazon’s revenue grew 10x while Berkshire’s 2x. That’s very impressive for Amazon. Its current revenue is half of Berkshire’s.
But, if you look at the net profit chart, you will hardly see Amazon’s net profit. Its net profit did grow from 190m to 596m, but it’s quite volatile and reported losses in 2012 and 2014. Berkshire, on the other hand, grew its net profit from 11bn to 24bn. Note that, Berkshire has nearly 100bn invested in publicly listed stocks. From this equity investment, it recorded only the dividends received as part of the net profit. If we look at the look-through earnings (both the dividends and retained earnings of the investees), Berkshire’s earnings will have been higher.
The net margin chart tells a clear picture that Berkshire’s profitability is much more stable than Amazon’s. Amazon’s profit margin is hovering around 0-1% now. I’m tempted to combine all the charts into one but the net profit and margin difference are too big that you will not be able to notice Amazon’s line.
Why is Amazon valued so highly?
Given that Berkshire is making 24bn profit and Amazon 600m, how to explain that both have similar market cap?
The answer is optimism. Berkshire is fairly valued at current price. But Amazon’s valuation is mostly based on optimism, which is derived from the growth potential. As seen above, its revenue grew 10x over the past 10 years and continues to grow at double digit rate. The market is less concern about the profitability for now. The idea for many of these fast growing tech companies is that once they reach a certain size with large market share, they will turn profit.
How to value fast growing companies?
One way to value these fast growing companies is 1) to estimate the revenue when they become mature, and 2) apply the sector’s average margin to get the net profit. After that, 3) we multiply the net profit by sector’s average P/E ratio, adjusted based on its growth and return on capital, to get total market value. In the end, 4) we discount back the estimated market value to present value.
For example, if Amazon becomes mature when it reaches 300bn revenue 7 years later, and the sector’s average profit margin is 5%, then the estimated profit is 15bn after 7 years. If we multiply it by P/E ratio of 20x, the market cap is 300bn. With 10% discount rate, we discount 300bn back to now, which is roughly 150bn.
Everyone can have different assumptions. If one assumes the profit margin is 10% when it matures, then with 300bn revenue, the net profit is 30bn. Multiply by 20x P/E, the market cap is 600bn, and after discounting back to now, it’s 300bn. If we multiply by 15x P/E instead, then the market cap is 450bn, and after discounting, it’s 225bn.
Common mistakes in valuing fast growing companies
As you can see, the margin of error in making this estimate is huge. That’s why it’s harder to value a growth stock.
Firstly, when we compound high growth rate for several years, a small percentage difference can make a huge difference. For example, 1m growing at 20% rate, compounded for 10 years, will become 6.2m. But at 23% growth rate, 1m becomes 7.9m, which is 28% higher than 6.2m.
Secondly, for such low margin business, a small percentage point difference makes a huge difference too. For example, with 300bn revenue, 5% margin generates 15bn profit, while 6% margin generates 18bn profit. With only 1% point difference in margin, the difference in profit is 20%.
Thirdly, a small change in P/E ratio can make a difference again. For example, 20x P/E is 11% higher than 18x PE. Long term P/E multiple is based on growth and ROIC. But for any moment, it can fluctuate based on market condition.
Fourthly, with such high growth assumptions, the Company may not live up to its expectation. By then, all the valuation will crash down. That’s why the biggest loss in the stock market takes place at the extreme optimism.
There are several other ways to value high growth stocks besides what’s described above. They are mainly different variations of assuming that the Company will grow to a certain size and the net margin will normalize to market average (from current’s extremely low level), so that it’s generating profit and cash flow. In the end, valuation is based on cash flow, not revenue.
What’s my valuation on Amazon?
I can’t value it. I can try, but the margin of error is too big that I have no confidence in my valuation. My assumptions can be as good (or bad) as yours. So, I don’t even want to try.
If we look at several super large retailers (mostly with brick and mortar stores), their net margins are below 5% (some are in losses). So, assuming, with some optimism, 5% net margin and 20x P/E for a mature behemoth, the revenue has to reach 350bn to justify Amazon’s current market cap of 350bn. That revenue target is 3.5x of last year’s revenue. At 20% growth rate, it’ll take nearly 7 years to reach the target. At 30% growth rate, it’ll take nearly 5 years. We haven’t even applied the discount rate yet. So, my assumptions above have to be even far more aggressive to justify current market cap of 350bn. If we assume net margin of 10% and P/E of 30x, then current revenue level is enough. The Company just has to cut cost to increase the profit margin.
So, here we describe a simple and basic framework to value very high growth companies that are currently earnings low margin (or even losses). You can use it to value Facebook or Netflix or Salesforce or other companies. All have high growth potential and are valued at very high P/E multiples. But beware of the pitfalls I mentioned above.
Amazon’s amazing performance
Amazon’s share price has been amazing over the years. Year after year, the revenue keeps growing at high rate and the market keeps believing that it will one day turn very profitable to justify its huge market cap. The share price returned 1830% in the past 10 years, beating Berkshire’s 140% by more than 10x.
I don’t envy those who make money in Amazon as I can’t value this Company properly and won’t buy it at any valuation over the past few years. If I want to envy, I prefer Priceline, which returns 4500% over the past 10 years, easily beating Amazon’s 1830%.
Although I can’t value Amazon properly with confidence, I think it’s grossly overpriced. For online retailers to have market cap that is 3x revenue and 300x earnings, I just can’t justify it with reasonable assumptions. Besides, it’s not able to scale by containing costs. For additional revenue, it has to invest a considerable sum in the warehousing, logistics and manpower.
Just looking at the price chart, many may assume that Amazon’s price will continue to rise. At this rate, the market cap will surpass Microsoft’s, then Google’s then Apple’s in few more years. But it won’t lure me to join the bandwagon. At such price and valuation multiple, the risk is the highest. I’d say good luck to the existing shareholders.