By Aswath Damodaran
Amazon and Netflix! Need I say more? Just the mention of those companies cleaves market participants into opposing camps. In one camp are those who believe that those who invest in these companies are out of their minds and that there is no way that you can justify buying these companies, perhaps at any price. In the other are those who argue that the old time value investors don’t get it, that these companies are redefining old businesses and will emerge as winners, thus justifying their high prices. The truth, as always, lies in the middle.
Amazon and Netflix: Reading the Pricing Entrails
Amazon and Netflix have been market wonders, rising in market capitalization even in 2015, a year when most of the market was retrenching. Notwithstanding the steep drop in stock prices of both companies this year (with Amazon down 23% and Netflix down 22%), Amazon is still up 36% over the last year and Netflix is up 34% during the same period.
One simple way to measure how much these companies have to come to dominate their playing fields is to compare them with traditional heavyweights in their businesses, Walmart, in the case of Amazon, and Time Warner, in the case of Netflix.
Is it possible that Amazon is worth more than Walmart and that Netflix is more than 60% of Time Warner’s value? The answer is yes and the only way to find out is by valuing both companies.
Amazon: The Field of Dreams Company
In a post in October 2014, I described Amazon as a Field of Dreams company, with a CEO (Jeff Bezos) who has been remarkably consistent in his push to make the company larger, even if that means selling products and services at cost, or even below, with the objective of using that market power to generate profits later. His vision for the company can be seen in this 1997 letter to stockholders and the company has certainly delivered on at least one half of that vision and increased its revenues in retailing initially, entertainment later and cloud computing recently, while generating little in profits over much of its existence. In its most recent earnings report on January 28, 2016, Amazon delivered its by-now-usual high revenue growth, delivered close to expected numbers on its revenues and guidance, but came in well below expectations on its earnings per share.
The market reacted strongly to the earnings per share surprise, with the stock price dropping 15% and Amazon losing $45 billion in market capitalization. The response followed a pattern of large market reactions to earnings surprises at the company, perhaps suggesting that the market is dreaming less about revenues and wanting more in profits from Amazon.
From a valuation perspective, Amazon’s results reinforced my existing story, with perhaps a tweak in the pathway to profitability.
During the last year, Amazon has taken actions that suggest that it is heeding the call to show profits, shifting more of its focus to cloud computing and laying off employees for the first time in its corporate life. To get a measure of the company’s current and expected future profit margins, I decided to take Amazon’s substantial technology and product development costs, which amounted to $12.5 billion in 2015 out of the operating expenses, and capitalize them, on the rationale that as growth started to slow, the growth in this cost would level off. That adjustment does push the current operating margin for the company from 2.09% to 6.58%, while also significantly raising my estimates of how much Amazon is reinvesting to generate its high revenue growth. Assuming that there is still room for revenue growth (especially in Amazon’s media and cloud computing business) and margin expansion (to 8.80%, the weighted average of the margins in the retail, media and cloud business) gives me an updated story for Amazon.
At $507 per share, the price on February 12, 2016, Amazon still looks over valued to me, but as you can see from the simulation, there is a sizeable probability that assuming higher growth and higher margins can get you values that exceed the price. If your rationale for buying Amazon is the cloud computing dream, I would suggest caution. The business is a big, potentially profitable one, but it is also one where other big players are stirring.
Netflix: House of Cards or Global Streamer?
Like Amazon, Netflix has a CEO in Reed Hastings, who has been both consistent and credible in selling a story of growth and potential. As the company approaches saturation in the US market, the growth story has a global twist to it. In its earnings report on January 19, 2016, Netflix beat expectations on both earnings per share and subscribers, with the growth in global subscribers tipping the scale.
While the report initially evoked a positive response, that price bounce quickly faded as investors took profits.
I have never posted a Netflix valuation on my blog, but in my prior valuations of the firm, I have tended to value it as a primarily domestic company that acquires others’ content and streams it to subscribers. While that remains the core business model, it seems to me that the story is shifting to a company that is increasingly global and more willing to generate its own content, with this earnings report providing further backing for the view.
Note that Netflix’s shift to content has mixed effects, decreasing profit margins (at least as I have defined them) while also reducing the reinvestment needed to generate growth (as the cost of buying content is replaced with the cost of making its own). The value per share that I obtain with these inputs is $61.44.
At $87.40/share per share, Netflix looks overvalued by about 40%, but as with Amazon, there are clearly combinations of revenue growth and margins that yield values that exceed the price.
To GAAP or not to GAAP?
Both Amazon and Netflix have a GAAP problem, insofar as neither company generates much in operating profits, using conventional accounting rules. I do believe that GAAP understates the profits at both companies, though not for the reasons used by many of the biggest cheerleaders for the company, including the adding back of stock-based compensation or the use of supplier credit as a source of capital (and cash flows). The problem is in the accounting categorization of expenses, with Amazon’s big investments in technology and content and Netflix’s even bigger spending on acquiring the rights to content (usually for multiple years) being treated as operating expenses. If we following accounting’s own first principle, which define capital expenditures as expenditures designed to create benefits over many years, Amazon’s technology investments and Netflix’s content commitments should both be moved out of operating expenses and the effects are captured in the table below:
In summary, reclassifying these basic expenses changes the picture of these companies from low margin companies, that grow revenues with very little reinvestment, to higher margin companies, that reinvest significant amounts to deliver higher revenues. It also has a favorable impact on value per share, not because of the obvious reasons (that operating income is increased) but because the reinvestment at both companies has been value-generating.
I don’t worship at the GAAP altar and have come to the conclusion that while accountants might do some things well, measuring earnings at companies that are not stable, manufacturing firms is not one of those things. They not only violate their own first principles (as evidenced by the treatment of R&D and contractual commitments as operating expenses) but also create inconsistencies across companies, making earnings at Amazon and Netflix not quite comparable with the earnings at GM or even at Walmart. That is one reason that I give short shrift to arguments against investing in Amazon, because it trades at several hundred times earnings, since cutting its technology development costs by $10 billion could quickly solve that PE problem while destroying the basis for the company’s value.
As businesses, the two companies share a common characteristic: they are willing to spend money now (on Prime and technology, in the case of Amazon, and original and acquired content, in the case of Netflix) to generate revenue growth, which they believe that they can turn into positive cash flows later. Both companies also realize that their growth ambitions will require them to grow outside the US, in less friendly regulatory standpoint and competitive environments. The biggest danger that the two companies face is that their revenue growth plans come to fruition, but that their costs stay high, as they have to keep spending money to keep their customers. There is one other characteristic that they share and it is one that may add to their value, though it is disquieting, at least to me. I have a feeling that Amazon knows more about my buying habits, and Netflix about my TV and movie watching proclivities, than I do myself. As an Amazon Prime user and Netflix subscriber of long standing, I know that they will use this knowledge to draw me deeper into their web, but I must confess that I am going in willingly.
Investor or Trader?
I have differentiated between investors and traders and no two companies better illustrate the divide than Amazon and Netflix. The two stocks have created a Rorschach test by forcing you to choose between staying true to your investing beliefs or capitulating to your pricing instincts. I would be lying if I said that I have not revisited my Amazon valuation from October 2014, when the stock was trading at about $300 and I found it to be over valued, as the stock doubled to more than $600 during the course of the next year or that I have not looked wistfully at Netflix, during its stock price rise last year. That said, I have made my peace, for the moment, with the market, on these companies.
I am an investor, for better or worse, and have to go with my estimates of value, flawed thought they might be, and will not buy either Amazon or Netflix, at their current prices.
At the same time, I have enough respect for the power of markets to not sell short on either stock, since I have seen what momentum can do with both stocks. You can call me chicken, but I don’t have the luxury of investing other people’s money!
Aswath Damodaran is the Kerschner Chaired Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and valuation to MBAs, executives and practitioners.