Why Amazon is now an overrated and overvalued stock

Why Amazon is now an overrated and overvalued stock

After many good years of sustainable earnings growth, Amazon is now an overrated and overvalued dot.com stock. Put simply, Amazon’s current valuation is absurd. While Amazon’s business model is excellent and offers a great B2C online service that many Australians appreciate, its hefty valuation no longer makes it a compelling investment. On top of that, Amazon’s once innovative and groundbreaking online business model is now stale and easy to replicate.

The online shopping arena is becoming increasingly crowded, with many traditional bricks and mortar retailers adapting to the online world of shopping. And unlike online businesses like Google, or tech giants like Apple whose technology and business models require vast sums of capital and intellectual capital to replicate, Amazon’s online business model is relatively simple.

As Amazon’s business model increasingly comes under threat by traditional retailers moving to an online setting, when considering its valuation, Amazon looks overpriced. The average price to earnings ratio of companies listed on the tech heavy Nasdaq 100 index is 23.12, while Amazon’s sits at a lofty 270.84. On forward earnings (consensus analyst forecasts), its P/E ratio, while still high, is slightly healthier at 110.15. But as you can see, there is no doubt that Amazon is comparatively overvalued.

Amazon’s hefty valuation doesn’t come without reason though. Sales growth over the past decade has been nothing short of stunning (see Picture 1, Source: Bloomberg), growing at an average annualised rate of 40.56%. Analysts don’t see this momentum slowing either. For the full year 2012, sales will total $US627.53 million, a 30% increase, and will increase a further 28.6% in FY 2013. But within an online retail environment that’s constantly changing, and with increasing levels of competition, the sustainability of Amazon’s sales growth must be brought into question.

As such, the risks of investing in Amazon are likely increasing. All it will take is one earnings miss, some bad news, or a poor management decision, and things could get ugly. Look no further than growth stocks Starbucks, Monster Beverages, Chipotle Mexican Grill, Priceline, and Netflix. All of these stocks commanded high P/E ratios, with strong revenue and earnings growth, along with a strong share price like Amazon. Unlike Amazon however, many of these stocks, after extended periods of growth, have fallen off cliffs. Many of these stocks had many months of steady gains wiped out in a matter of days, following either an earnings miss or poor managerial decision.

Netflix is the perfect example of what can go wrong for a growth stock. Netflix, like Amazon, was a market darling. It was rapidly growing revenue and earnings, and had a rosy outlook according to many Wall Street analysts. Emerging from the midst of the global financial crisis, the share price of Netflix went crazy, rising over +1,500% in three years, commanding a lofty PE ratio of close to 80. But with such high expectations surrounding the future of Netflix, any disappointing news could have spelt disaster. And it did. But it wasn’t a poor earnings result in this instance, but rather poor management decisions. Since management’s infamous pricing bungle, Netflix shares have fallen over 80%, causing long-term shareholders plenty of headaches. Amazon, too, could be destined to a similar fate; market darling to market dud.

From a short-term trading perspective, Amazon looks attractive. The long-term trend is up and short-term buying momentum is building, with prices looking like breaking all time highs at $US246.71. Upon a technical break above $US246.71, the trend could easily accelerate and head toward $US300 a share, a 20% increase from current levels. But could the price of Amazon really hit $US300, ignoring its ridiculous valuation, the risk of a poor earnings result, and the increasing threat of competition? Unless Q4 earnings are overly positive, it’s difficult to see that happen.

Undoubtedly over the next few weeks, especially if global markets continue to rally, the share price of Amazon could rise another 5%. If global markets do continue to rally, however, I’d much rather have my money in cheaper growth stocks with far better underlying fundamentals like Apple, eBay or Google. And if global markets stagnate or fall, I’d still be happy holding these stocks. Even though Apple is breaking to new highs, on a valuation basis, Apple looks incredibly cheap, especially when compared to the likes of Amazon. If I were an Amazon investor, I’d be locking in some great gains and reinvesting the profits in Apple and Google.

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