Friday, February 1, 2013

Amazon, Apple, and Intrinsic Value

Here's a Fortune article that compares Apple (AAPL) and Amazon (AMZN) that also provides some useful charts.

Apple vs. Amazon: Bizzaro valuations revisited

Consider this:

Amazon's average earnings over the past five years was $ 658 million.

If Amazon grows it's earnings 25% per year off of that base for fifteen years, the company's annual earnings would grow to ~ $ 19 billion.

Less than half Apple's current earnings (and roughly equal to Apple's five year average). That kind of growth by any company for that amount of time would be impressive to say the very least. Who knows, maybe Amazon will prove they can pull off that kind of business performance.

Of course, Amazon actually lost money over the past twelve months. That's why I used the company's 5-year average earnings. That way there was actual earnings to use as a base for that 25% earnings growth.

Here's the progression of the Amazon's earnings over the past 5 years:

2008
$ 645 million

2009
$ 902 million

2010
$ 1.152 billion

2011
$ 631 million

2012
$ - 39 million

Over that same time frame Amazon's sales has more than tripled!

Impressive, but they're not making a whole lot of money in the process.

Well, at least not yet. I don't doubt that Amazon is likely being built for the long run into something quite valuable.

Figuring out just how valuable (or the likely range of intrinsic worth) and the timing is the tough part. If, when, and how much the investments they are making now will pay off just isn't easy to judge (at least for me).

As a comparison, Apple's earnings over their past five years (fiscal year ends in September) has gone from $ 4.8 billion in 2008, to $ 41.7 billion in 2012.*

Over the same time frame Apple's sales have increased nearly 5-fold.

Apple's enterprise value (market cap minus net cash and investments) is currently roughly 2.6x that of Amazon's. For some perspective, if Apple's earnings were to shrink at a 10% annual rate from here, in three years the company would approximately still generate as much cash as Amazon's entire current value.
(i.e. Adding together the earnings produced in total over the three years roughly equal Amazon's enterprise value.)

In contrast, at the 25% growth rate assumed above, Amazon would still not produce, in total, enough earnings to equal its current value after fifteen years.
(Again, adding together the earnings from each of the fifteen years. Imagine how long it would take if the company's earnings were to increase at a lesser rate?)

That doesn't necessarily mean Amazon's overvalued (or that Apple is not), but it might at least be a rough indication of which of these two companies, near current valuations, requires an investor to go further out on a limb; which company is more dependent on very good things happening for a very long time to justify their stock price.

What if things don't go quite as well as expected? Margin of safety is always a key principle no matter how favorable a company's prospects seem to be.

Back to Apple. What are normalized earnings for the company? I certainly have no idea. When earnings change that much in a relatively short amount of time it creates a big challenge judging value for any investor. Maybe it's economics are about to go in reverse (and fast). Maybe not. Does the company's earnings power roughly stabilize near current levels? What if normalized ends up being closer to the five year average (or even less)? Considering the amount of competition and the kind of products Apple sells, it's not hard to imagine the company's now exceptional margins coming under some pressure over time.

My point is Apple may still have more than respectable future prospects but, whenever there's a huge jump in earnings capacity (and going from $ 4.8 billion to $ 41.7 billion in five years certainly qualifies), it creates real challenges for any investor who's trying to figure out the intrinsic value of a company.

A spike in earnings like that increases the possibility of valuation misjudgments.**

More on Amazon and Apple in a follow up.

Adam

No position in AMZN; established a long position in AAPL at much lower than recent prices

Related posts:
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

Ultimately, of course, when it comes to valuation it's the cash that will be generated over an extended period that matters. Near-term earnings may or may not be a good proxy for that. As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Amazon, of course, is less of a pure tech business than Apple but, at least to me, it still has difficult to predict prospects. Occasionally, certain tech stocks have sold at enough of a discount that owning a very limited number of shares made sense to me. In other words, the price was cheap enough relative to the per share cash generation (and, in some cases, net cash on the balance sheet) that it provided a substantial margin of safety. Otherwise, the future prospects of most tech stocks just aren't predictable enough for my money. So I'm not exactly trying to anticipate the next big thing in tech. The best businesses have durable economic characteristics. Tech stocks too often generally do not. Those with seemingly attractive economics today frequently prove to have far less attractive economics down the road.
** As always, I have no idea or opinion on how these two stocks might perform in the near future or even longer.
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