Amazon is on a p/e of 500 – but I’m happy to keep my shares

Amazon launched its first smartphone last week – the Amazon Fire phone.

It doesn’t represent any sort of leap forward in smartphone technology, according to reviews. So it probably won’t take a huge amount of market share from Apple or Samsung/Google.

Meanwhile, both Apple and Google are eating into one of Amazon’s traditional core businesses, selling music and video content.

So is Amazon’s new smartphone just a desperate bid to preserve market share? Or is it another ballsy, far-sighted move by Amazon’s boss, Jeff Bezos – one that will pay off in the end?

I think it’s the latter. And that’s why I’m willing to hang on to my Amazon shares – even although they trade on an eye-watering price/earnings ratio (P/E) of 500.

You might think I’m mad – but let me try to persuade you otherwise…

What’s Amazon’s new phone like?

I’ve not seen one of Amazon’s phones, but it sounds like they’re pretty similar to your average iPhone, but with two fresh add-ons.

One is a semi-3D capability that has been greeted with a ‘meh’ reaction by most reviewers. In truth, I don’t really understand how this 3D function works – I’ll have to wait and see a phone before I can do that.

The other improvement is a ‘recognition engine’ which has been received much more warmly.  It’s called Firefly and is a sort of audiovisual search tool. It recognises books, various consumer goods, music, video and more. And once the phone has recognised the item, you can immediately put it in your Amazon shopping basket.

“Not only was it effective”, says Gizmodo, “it was kind of beautiful”.

So it’s pretty obvious that Amazon is launching the phone in an effort to sell more stuff. Purchasers of the phone will also get a year’s free membership of Amazon Prime, which normally costs £79.

Prime offers free delivery on many purchases, the opportunity to ‘borrow’ books to read on your Kindle, and access to a wide selection of video titles. Amazon says that Prime customers spend four times as much on Amazon as other users, and that half of Amazon’s sales are to Prime customers.

So if the Fire phone can significantly boost the number of Prime customers, it will probably prove to be a savvy move by Bezos.

Now, not everyone is convinced that the phone launch is a smart move.

For example, Bruce Greenwald, a finance professor at Columbia Business School, made some negative comments to the Guardian. “This sequence of crazy initiatives in areas where they have no competitive advantage is about sustaining an unsustainable stock price… Amazon owns the books market, but what is happening to the value of that monopoly? They have a core business in which they are dominant, it’s going away and they are thrashing around trying to justify their $150bn market capitalisation.”

Is Greenwald right? I don’t think so.

Yes, Amazon faces growing competition. In digital content, it is competing with Apple, Google, music streaming service Spotify, and many others.

And on the physical consumer goods side – in other words, items that are delivered from its warehouses rather than online – the likes of Tesco, Argos and Walmart are all growing smarter about online retail. These chains also benefit from owning large store networks which are useful for customers who like to “click and collect.” Amazon isn’t so well placed for ‘click and collect.’

Greenwald is also right to highlight Amazon’s high valuation. However, I believe that valuation can be justified and that’s why I’m happy to hang onto my shares.

Why Amazon’s ‘crazy’ share rating is justified

No other online retailer offers such a large variety of products for sale. And Amazon is still growing its sales faster than the growth rate for overall e-commerce around the world. Last year, Amazon was the ninth-largest retailer in the world. Consultancy Kantar expects it to be the second-largest by 2018.

Amazon’s network of warehouses is also a very useful asset. It has 106 ‘fulfilment centres’ around the world, of which ten are in the UK. It is also trying to improve its ‘click and collect’ capacity by offering collection points at some London Underground stations.

Amazon also has a great record of investing for the long term. When Amazon launched Amazon Web Services in 2005, many observers doubted that the company could become a major player in this field – providing services to businesses. But, according to The Motley Fool, it now controls more than 30% of infrastructure for the ‘cloud’.

The point is, there will come a time when Amazon can afford to slow down the pace of growth and allow its profits to rise dramatically. When that happens, today’s valuation won’t look so crazy.

I’ll freely admit that Amazon is probably the highest-risk stock in my portfolio, but I’m happy to hold for further growth to come. And the Fire phone will play its part in achieving that growth.

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  • Shoveller

    Domiciled in Luxembourg, Amazon pay next to no corporation tax. That is about to change and with growing numbers of consumers boycotting Amazon, caution says don’t bank on the potential described.

  • Clive

    p/e of 500 – it’s different this time – “No other online retailer offers such a large variety of products for sale”

    yeah, yeah, heard it all before, we’ll see what happens

  • Lewis81

    I get the growth argument about Amazon and also that it is suppressing margins in the short run to fuel accelerated growth but everything has its price!!!!

    Let’s take a look at gross revenues which should be a good indicator of longer term growth without the hidden complications of short term margin suppression at Amazon.

    Google grew revenues ~19% in 2013 and has a P/E of 30 ish
    Amazon grew revenues ~22% in 2013 and has a P/E of 500 ish!!!!

    Lets not even start to talk about the margin difference between the two for the moment.

    Does that extra 3% in revenue growth YoY really deserve it a multiple of nearly 17 times higher than Google???

    I’d also argue that Amazon will never realise the margins that Google enjoys even after it diversifies its business. Despite the PR headlines, today and in the foreseeable future it remains primarily a retail business.

    I just cannot get my head around the valuation! Now of course Im not saying the stock price wont rise from here, the unsustainable can go on for a long time, but as a long term investment I just don’t see the upside.

  • Lewis81

    So I cranked a few extra numbers…… appreciate this is a very simplistic way of looking at it and the numbers are rounded.

    Gross Revenue growth has been slowing from 41% in 2011 to 27% in 2012 to 22% in 2013 with gross revenues of $74bn in 2013. It will be interesting to see how they manage to offset this slowdown in growth rates if at all in 2014.

    The critical question comes down to what margin you think it can operate at without damaging sales (not just growth but existing sales). If you take a crude 5% margin on the $74bn of 2013 revenue then you get to $3.7bn of net income giving us a P/E of about 40 at todays valuation. If you push the crude margin number to 10% then you get $7.4bn of net income and a 2013 P/E of around 20.

    Both these numbers seem a lot more reasonable than the headline 500 but I just dont think Amazon will be able to grow margin that much without growth going into reverse. Walmart margin is currently 3.4% as a benchmark with much better pricing power. And even if we take the estimate of 5% margin with a P/E of 40 this still places the current price at a P/E premium to Googles ~30 with a smilar rate of revenue growth.

    Personally I still think there are better investment options elsewhere

  • Marko

    I order a lot of stuff from Amazon. It is definitely the best online shop in the world. Has pretty much everything and usually at the lowest price.

    I’m not sure how they will increase their thin margins though without putting their prices up thus losing customers.

  • Dialogue

    Ed, you admit that Amazon is the riskiest company in your portfolio. But surely there are equally risky companies out there with similar downside but much more upside? It just seems wrong to me.

  • CKP

    Wouldn’t touch Amazon shares with a bargepole. It is currently operating as a charity masquerading as a tech/retail stock run for the benefit of consumers. Clearly the long term plan is to crush competition and gain world domination. At this point, it will be broken up by anti-monopoly regulators. It’s only way to survive would be to diversify into multi-national politics to ensure it’s survival. I may buy the shares if Bezos runs for president of the USA.