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What's the Appropriate Valuation for Amazon?

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Amazon (AMZN - Free Report) is scheduled to report quarterly earnings after the closing bell on Thursday, at which point investors will get a glimpse into the unique financials of the world’s second biggest company. Positive results could propel Amazon’s share price high enough to become the first ever Trillion dollar company, while a disappointing report could topple the internet giant from its perch atop a sky-high valuation.

Let’s take a look at what the market is expecting.

First, the basic numbers. The Zacks Consensus Estimates for revenues is $53.45B, a 40% increase over the same quarter in 2017. Earnings are expected to be $2.49/share – a 522% increase, although percentage comparisons don’t necessarily apply to Amazon the way they do to more traditional companies.

Even though Amazon has been public for over 21 years, it continues to defy conventional valuation metrics.  Although high-growth companies often enjoy a rich valuation during the period when they are expanding and spending heavily on capex, it’s unprecedented for a company of Amazon’s size to trade at a forward P/E ratio of 144X.

Unlike the other FANG high-flyer Netflix (NFLX - Free Report) who’s earnings are fairly predictable, Amazon has a history of significant beats and misses.

The options market is currently pricing in the expectation of a $90 move in Amazon shares.

For comparison purposes, the world’s largest company – and the other leading candidate for the first entrant to the trillion dollar market cap club – Apple (AAPL - Free Report) , trades at a forward P/E of just 17X, basically the same as the S&P 500.

Powerhouse brick-and-mortar retailer Macy's (M - Free Report) trades at less than 11X.

So what keeps investors convinced that Amazon continues to deserve a premium valuation?  The fact that it keep growing at a premium rate.

It’s basic math that early-stage companies that are spending every cent of cash flow (and sometimes much more) in order to pursue growth opportunities can trade at triple-digit P/E ratios with the expectation that once they stop spending, the revenue streams they have built during the growth stage will equate to net earnings that justify their share price at a more traditional ratio. Basically, investors have to guess when these companies will “grow into” their share price.

Amazon has defied the norm by continuing to expand into newer and higher-margin businesses. Over the past few years, Amazon has significantly reduced the percentage of revenue it gains from its relatively low-margin core business of internet retail sales and now receives over a third of revenues from the relatively high-margin categories of third-party sales, Prime subscription services and Amazon Web Services.

So the major issues investors will be examining in the quarterly earnings report will be the growth of these newer businesses, specifically web services.  Given Amazon’s high valuation, significant continued expansion into higher-margin, higher growth areas is probably more significant than the raw sales and earnings figures.


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