Amazon is Fairly Valued

Price Target: $2854

Most people are convinced Amazon will completely dominate global retail and any other category it chooses to enter. Given the company’s track record it’s easy to see why this narrative exists and the stock is up over 80% in the last year alone! I thought it would be interesting to dig a little deeper into the company to determine whether the stock is still worth buying at current levels.

Based on the analysis below, I believe Amazon is now fairly valued. Keep reading for details on my valuation assumptions that lead to this conclusion.

Revenue Growth

Amazon breaks down its businesses into 3 segments – North America, International and AWS.

In order to project revenue growth for Amazon going forward, I think it’s helpful to project growth for each segment. Given COVID has accelerated the move from physical retail to online retail, I expect revenue in North America and International to grow faster in 2020 than in 2019. This is clearly occurring based on Amazon’s Q3 2020 results. North America revenue was up 39% YoY and International revenue was up 37% YoY. I therefore project revenue growth of 38% and 35% for 2020 in these two segments, with growth rates normalizing in 2021 and beyond as future growth was moved forward to 2020. My assumptions for growth in each segment are on the ‘Segments’ tab of my model.

Are these revenue growth projections reasonable? Let’s sanity check them.  The total value of non-durable goods sold (both online and offline) in the U.S. in the last twelve months was $3.1T. Groceries alone constituted $1.8T. Amazon’s estimated 2020 U.S revenue of $236B represents just 7% of all non-durable goods sales. About 15% of non-durable goods are sold online, so Amazon represents almost 50% of all online sales. If you believe that more spending will shift online (which I do), and that Amazon will continue to own a big share of online spending, then you might conclude that it really is day one for Amazon. Assuming, sales of non-durable goods grow at 3% over the next 10 years, Amazon’s 2030 U.S. revenue forecast of $629B still only represents 15% of all non-durable goods sold in the U.S in 2030. This seems reasonable if not conservative.

AWS revenues grew 29% YoY in Q3 2020, so I model 30% growth for 2020 and 25% in 2021, with growth rates declining going forward. While AWS is clearly the current market leader in cloud, competition from Microsoft and Google is only going to intensify going forward.

Margins

Margins are a very important factor in Amazon’s valuation. Amazon’s overall operating margins in 2019 were 5%, with North America at 4%, the International business losing money at -2% and AWS at 26%.

I expect margins in North America to stay steady over the next 10 years and International margins to gradually improve to 3% by 2030. I expect AWS margins to improve slowly as well to get to 30% by 2030. Based on these assumptions and the revenue growth prospects for each business line, I expect Amazon’s operating margin in 2030 to be 7%.

Discount Rate and Terminal Value

Just like in my previous valuations, I assume a discount rate of 3%, which reflects my long run inflation expectations. While Amazon has $23B in debt, this is a tiny fraction of the equity value. Amazon has not issued meaningful equity recently to my knowledge, so a discount rate based on the cost of equity and debt remains academic, as opposed to realistic, for a company like Amazon.

If Amazon reaches over $1T in revenue by 2030, it’s likely the market will value it at 25x FCF even if growth is relatively slow at that point. You can change this assumption on the main page of the model if you disagree.

Valuation Results

Based on the key assumptions above, I arrive at a per share value of $2854 for Amazon. This is 11% lower than the closing price on 12/2/2020. The model is available here if you’d like to change the assumptions.

Upside Potential

Amazon’s Ads Business generated $4.2B in revenue in Q2 2020. This represents 41% YoY growth, which contrasts sharply with Google’s decline in YoY ad revenue in Q2 this year. Granted Google did $30B in ad revenue in Q2, so it’s a much larger base, but this shows advertisers desire to spend with Amazon given the high conversion rate to purchases.

It’s entirely possible that new multi-billion dollar businesses develop within Amazon over the next ten years. Health care, for example, may be an area Amazon expands into. Another could be finance, serving sellers on the platform as well as customers making purchases. In many ways it feels like it is still Day 1 at Amazon, so it would not surprise me if Amazon ended up at $1.5T in revenue by 2030 as opposed to the $1T that I’m forecasting.

Downside Risks

The biggest risk in my mind is regulatory. Amazon has the ability to squeeze third-party sellers on its platform in multiple ways and has been accused of doing so for years. The reality is that most small third party retailers need Amazon, and as Bezos pointed out during his recent testimony to Congress – “Third-party sellers in aggregate are doing extremely well on Amazon.” I would be surprised if regulation results in a fundamental change to Amazon’s business given the size of the retail market and the number of competitors, both physical and online.

Notes

Amazon’s FCF is affected by changes in working capital, but I ignore this in my model, because I believe there’s a limit to how much Amazon can continue to optimize accounts receivable and accounts payable. I also do not add back stock-based compensation to net income to boost FCF. While stock-based comp is indeed a non-cash expense, equity holders effectively pay for it, so I prefer not to add it to FCF given I use FCF to value shareholder equity. As a data point, stock-based compensation was $7B in 2019, which would boost 2019 FCF by over 20% in my model.

I don’t include long term leases as debt because these are an operating expense and are captured in the operating margins.

I ignore interest expenses because of the low expected cost of debt going forward and the minimal impact this has on the valuation. If you’d like to incorporate this expense you can easily do so by including it in the tax rate going forward.

Disclosure: I am long AMZN