If you don't own Amazon, don't start now

Despite the recent slump in share price, Amazon's valuation remains sky-high.

By InvestorPlace Jan 3, 2012 3:01PM
Credit: Amazon
Caption: Kindle FireBy Dan Burrows

The nattering and chattering over Amazon's (AMZN) foray into the tablet field with the Kindle Fire -- a product that costs more to produce than the company is selling it for -- is ultimately just a lot of smoke.

Yes, absolutely, Amazon is risking short-term profits and margins. So what? CEO Jeff Bezos always has managed the company beyond the quarterly demands of Wall Street's expectations. Amazon's razor-thin margins always have been under close scrutiny, and any time they come up short, investors punish the stock.

That's fair enough -- at least for traders and short-term players. At a scant 2%, Amazon has a lower net profit margin than Wal-Mart (WMT). When you're running a retailer that lean, a few hundredths of a percentage point pop in the cost structure can easily flip a net profit into a net loss.

More important is that the company's strategy is sound. Amazon is an online retailer, and the new frontier in e-commerce is the tablet. If the company needs to start with a loss leader to get customers in the door, so be it. Supermarkets have been doing this for decades. Those overabundant displays of fresh produce that greet you upon entering your local supercenter? Most of it spoils and is thrown out at a loss. The vine-ripe tomatoes are window dressing. The profitable products are the ones in the aisles.

But most important is that all this fretting over the Kindle Fire -- and the breathless, incomplete data on how holiday sales might have fared -- obscures a far more critical fact about Amazon's stock: It looks very, very overpriced.

If you have Amazon in your portfolio, what you decide to do with that position depends on your initial cost basis, as well as other considerations, such as your investing horizons and other holdings. Amazon is by no means an automatic sell, if only because it has proven again and again to be a core, long-term holding. InvestorPlace contributor Kevin Kelleher is right when he says Amazon investors should wait out the storm.

However, I sure wouldn't be comfortable initiating a position at these levels. Here's why: Based on the stock's five-year averages, it currently trades at enormous premiums to its trailing and forward price-to-earnings ratios. That's to say, through good markets and bad, by both actual and estimated earnings, investors are paying historically out-of-whack sums for each dollar in earnings.

Amazon's forward P/E currently stands at 87 vs. a five-year average of 56, according to data from Thomson Reuters. By trailing, actual earnings, Amazon's P/E is a whopping 92 vs. a five-year average of 71. Clearly investors have been willing to pay big premiums for Amazon's growth, and they've been rewarded in kind. The stock is up 340% during these past five years.

But valuations, like so much in investing, have a nasty habit of reverting to the mean -- especially when investors get hinky about bold, new (and expensive) initiatives.

Shares in Amazon sold off ahead of the market's New Year's break after Goldman Sachs warned that fourth-quarter sales could miss Wall Street forecasts. It sure wouldn't be the first time that's happened. Amazon has missed analysts' average top-line estimate in two of the past four quarters. It also has blown the Street's bottom-line forecasts in two of the past four quarters, and three of the past eight.

So although Amazon's strategy is sound, the stock simply appears too pricey at current levels. When it comes to long-term investing, valuation is (almost) everything. With a history of missed expectations, Amazon likely will offer investors a more attractive entry point in the not-too-distant future.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned stocks.

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Jan 3, 2012 5:03PM
Another case of somebody shorting the stock they mention .....
Jan 3, 2012 9:40PM
AS A KINDLE OWNER - The product is going to sell very well, because it is absolutely great. The available apps are growing, and tons of them are free. Tons of great books are available free, and I can surf the web and work my email... The device has a great screen, and works great. It's a wonder I haven't worn it out, I use it so much. I have an ACER that I used to plop on my lap every night in the living room, while watching the news... but this is tiny and convenient. The warm-up is immediate, and I love that!
Jan 3, 2012 5:10PM
I think the writer is correct in his analysis, even if he's talking his book.  I don't see why so many people feel so strongly about holding a stock with such a lofty valuation.  I don't see the growth, and would not be surprised if AMZN is down 30% from here by year's end.

A lot of AMZN bulls are just momentum players.

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