Evaluating the true value of Amazon’s stock

Such questions typically arise with small-cap outfits that are growing like weeds, or with big companies selling a volatile commodity like oil. But Amazon is neither of those. It’s a titan, the ninth-largest company on earth by revenue, and full-year sales have moved in only one direction since it went public in 1997. Yet incredibly, it’s still delivering blockbuster growth. It’s also a wealth-creation champ, doubling in value since the pandemic arrived to become the world’s fourth-most-valuable company.

Amazon is a true wonder, among the all-time greats. But what it’s worth is an entirely separate question, answered not by the company but by the market. A careful look suggests the market may have stars in its eyes.

The evidence shows up in some fundamental measures that are often overlooked. The bedrock of a company’s value isn’t revenue or earnings per share or a P/E ratio or the other numbers featured in most Wall Street analysis. It’s capital—how much of it has been put into a company, how much it costs, and how much it earns. The concept is simple. Take the return on a company’s total capital and subtract the cost of that capital. The result is what financial economists call economic profit, also known as economic value added (EVA). If it’s greater than zero, the company is creating wealth. Otherwise it isn’t. Research has found that this method of analyzing companies is much more predictive than looking at EPS.

Achieving non-negative EVA isn’t easy. In fact, zero isn’t a bad number. It means the company is producing a return that just matches the overall market return on an investment of equal risk. It’s fine, but it offers investors no reason to invest; they could do just as well elsewhere.

Amazon—no surprise—does way, way better than zero. In the four quarters through this year’s first quarter, its EVA was a stupendous $22 billion. So says Institutional Shareholder Services, the big proxy advisory firm, which calculates EVA data for thousands of companies. Getting to that number is easy. We just take Amazon’s return on capital for that period (21.4%) and subtract the cost of capital (5.6%). The result (15.8%) is called the spread. Multiply Amazon’s average capital during that period ($183.5 billion) by the spread, and that’s the EVA of $22 billion.

But stock prices aren’t based on past performance. They’re based on expectations of future performance, which is where Amazon’s current stock price runs into trouble.

Any given stock price embodies a set of expectations, so I asked Anthony Campagna, an ISS managing director, to calculate the EVA expectations baked into Amazon’s recent stock price of about $3,600.

Result: To justify the recent price, Amazon’s mammoth EVA would have to increase at an 11.8% annual rate for the next 20 years.

Is that likely to happen? You could argue that it’s not only likely, it’s a slam dunk. Over the past ten years, Amazon’s EVA has grown at a 37% annual rate. But look closer. That 37% rate was juiced heavily by a 97% increase in the pandemic year, which with luck will remain an outlier.

To get a fuller sense of the future, note that Amazon’s return on capital has been declining for years. That’s to be expected; as a company grows, high-return projects that are big enough to move the needle get harder to find. Back in 2008, the company’s return on capital was a towering 45.5%; in the four quarters before the pandemic, it was a ho-hum 16.4%. At the same time, today’s ultra-low interest rates have helped depress the company’s cost of capital to its lowest ever (5.6%).

So here are three questions for Amazon investors:

—Over the next 20 years, do you think Amazon’s cost of capital on average will be higher or lower than it is today?

—Do you think Amazon’s return on capital will increase, hold steady, or decrease over the next 20 years?

—The big question (and forgive the length, but this is what it’s all about): Given your answers to the two previous questions, will Amazon be able to add new capital such that the spread times the capital will produce EVA of $270 billion in 2041 alone? Because that’s what growth of today’s EVA at an 11.8% compound annual rate implies—meaning that’s what it would take to justify today’s stock price.

If you’re skeptical of that scenario coming to pass, as you can tell I am, you should know that we’re way out of step with Wall Street opinion. Of the 47 analysts following the stock, 43 rate it a “buy” or “strong buy.” The others rate it “hold” or “underperform”; none rate it a “sell.”

It’s rarely comfortable to be out of step. But maybe this is a good time to remember Warren Buffett’s famous admonition—especially the second half of it—to “be greedy when others are fearful and fearful when others are greedy.”