Investors, take note. During the first trading week of 2021, Amazon’s AMZN stock slid by 2.8, even as the S&P 500 rose by 2.7%. What are we to make of this, given that Amazon’s stock increased by more than 64% over the course of 2020, a year in which the S&P 500 rose by about over 16%? What are we to make of this against the backdrop of a pandemic and Presidential-incited mob assault on the U.S. Capitol building?
Stock prices are driven by a combination of sentiment and fundamentals. In this post I offer a few insights about how sentiment and fundamentals have influenced and will influence the long term performance of Amazon’s stock.
Consider a hypothetical question. Suppose that at the end of 2010, Jeff Bezos took Amazon private, paid book value to do so, and continued to run the company exactly as he actually subsequently did. In this hypothetical, there is an important difference between Amazon being public and being private. If private, Jeff Bezos would have earned annual returns on his Amazon holdings from the cash generated by Amazon instead of the appreciation associated with the trading of its stock on public markets.
Given that information about 2020 is still incomplete, I will focus on financial data through the end of 2019. Between the end of 2010 and the end of 2019, Jeff Bezos actually earned an average annual return of 30% by holding his publicly traded Amazon stock. If instead, he had received the average return on equity for that period, based only on Amazon’s earnings, he would only have earned 10%.
The difference between 10% and 30% is large, and it is important to understand the degree to which the difference reflects investors’ expectations about Amazon’s performance going forward. That difference does not necessarily suggest that Amazon’s stock is overvalued on fundamentals. Indeed, Amazon’s return on equity rose substantially in 2016, climbing above 10% for the first time in five years, and then in 2018 and 2019 climbing above 20%.
To gain some insight into forecasts of Amazon’s future cash flows, consider the opinions of some of the key analysts who follow Amazon. I focus on sell side reports written by analysts at four firms. The four firms, all of which provide long term forecasts of Amazon’s free cash flow, are: Cowen, Credit Suisse CS , Jefferies, and SunTrust Robinson.
Amazon’s closing price on January 7 was $3,162. The corresponding target prices for the four firms ranged from a low of $3,400 for SunTrust Robinson to a high of $4,150 for Cowan. The SunTrust Robinson target price corresponds to a return of 7%, while the Cowan target price corresponds to a return of 30%. The beta for Amazon stock is about 1.2, which suggests an expected return, for a fairly valued stock, that is much closer to 7% than to 30%.
All four sell side analysts provide opinions about what they consider to be Amazon’s weighted average cost of capital. These opinions range from 9% for Jefferies to 10.5% for Credit Suisse. The other two firms use 10% as Amazon’s cost of capital.
The range of estimates for Amazon’s cost of capital is reasonably tight. Keep in mind that that cost of capital represents investors’ best estimate of the future annual return to Amazons’ investors, meaning the combination of stock holders and debtholders. In terms of book value, Amazon is roughly 50-to-60% equity financed. However, its price-to-book ratio is about 20, and so in market value terms, Amazon is mostly equity financed.
Historically speaking, has Amazon consistently generated a return on invested capital (ROIC) that is at least 9%? For 2011 through 2019, the answer is no, as Amazon’s ROIC was about 6%. However, in 2018, Amazon’s ROIC jumped to 14% in 2018 and to 11% in 2018. Those jumps were significant, and came to be reflected in the market return to its stock.
Here is something important to recognize for how investors view the long term prospects of Amazon. Implicit in all four analysts’ calculations is Amazon being able to generate a long term ROIC in excess of its cost of capital. By long term, I mean the time period after 2025.
It is not inconceivable that Amazon will be able to earn superior ROIC for the next several years. But the next few years is not the long term. Investors need to keep in mind that Jeff Bezos will not be Amazon’s chief executive forever. In addition, without strong barriers to entry, it is difficult for most firms to earn more than their cost of capital in the long term. Indeed, the odds are against doing so.
One other thing. Analysts at Cowan and Credit Suisse assume that Amazon will be able to generate robust growth in free cash flows while shrinking their net fixed assets over time. In the short term, it is possible to do so, by incurring depreciation charges in excess of capital expenditures. Indeed, Amazon did so in 2015, 2016, 2018, and 2019. However, doing so in the long-run, meaning every year after 2025, is another matter.
The improvements to Amazon’s ROIC in 2019 and 2019 occurred because for the period 2011 through 2019, Amazon stepped up its capital expenditures. Specifically, the ratio of its capital expenditures to unlevered cash flows during this period was 55%, sharply up from the prior decade when it was 18%. Investors should view, with great suspicion, long term forecasts of robust free cash flow growth that occur while net fixed assets decline to zero.
One last thing. Firms that consistently earn more than their cost of capital become targets not just for competitors, but also for regulators. Regulators in both the U.S. and the European Union have their sights on Amazon for monopolistic behavior. Whether justified or not, these regulatory initiatives make it difficult to maintain ROIC above the cost of capital in the long run.
Behavioral economists use the term sentiment to mean investors mis-reacting to information about fundamentals. Because in the short-term sentiment effects can be large and distortionary, short term investing is largely about betting on sentiment. Sentiment is much more volatile than fundamentals, and that volatility both reflects and supports wide dispersions in beliefs about where Amazon’s stock is headed over the next twelve months.
Among all 46 sell side analysts following Amazon, the range of target prices is $3,048 to $4,500. Time will tell where Amazon’s stock ends 2021 relative to this range. At some point, Amazon’s fundamentals will likely catch up with its stock price. Time will tell whether Amazon will be able to beat the odds in the long run, and earn a return on invested capital in excess of its cost of capital. Investors would be well served to keep both issues of their radar screens.