Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) compete in a few important business areas; Apple’s iPad compares to Amazon’s Kindle in tablet rankings, and both devices come pre-loaded with each company’s respective online media store. But, as technology companies, the metric most often used to compare Apple and Amazon is the valuation of their shares, especially as both companies soared to global prominence under the guiding hand of an innovative leader, late Chief Executive Officer and co-founder Steve Jobs in the case of Apple, and current Chief Executive Officer Jeff Bezos in the case of Amazon.
While both companies appear to be at the top of their game, despite the increasingly negative sentiment about Apple’s future growth potential, their movement on the stock chart has been quite different. Amazon’s shares have climbed nearly 40 percent in the past 12 months and Apple’s stock has dropped about 30 percent in the same period, prompting many observers to question why their stock prices have diverged so much. But a recent article published by The New York Times cataloged the dangers of such a comparison. The basic premise of the publication’s argument is that growth should not be the only reason for such vastly different valuations.
When the question of stock valuation is put forward, the most common explanation for a divergence is unequal growth. After all, when a company successfully convinces investors that its earnings will continue to increase, an enthusiasm grows around its shares, and, as a result, they tend to perform well on the stock chart. A comparison of growth estimates held by Wall Street analysts for Apple and Amazon in 2014 provides evidence that supports that thinking; forecasts call for Amazon’s earnings next year to be 66 percent higher than those predicted for 2013, and a 10 percent increase is expected for Apple.
However, there is another consideration that needs to be addressed to make an accurate comparison. While growth trajectories may clearly suggest that one company’s stock will likely outperform its competitor’s, whether the market has already factored the expected-growth into the stock price can affect movement on the stock charts. “It is possible to pay too much for excellence,” as the Times noted.
There are many ways to measure how much credibility investors ascribe to a company’s “growth story,” or, in other words, how much the market has factored the expected growth into the stock price. One method is to assess what price investors are currently paying for a company’s free cash flows, meaning the dollars it generates in profits minus spending on plants and equipment.
In the case of Amazon and Apple, the results of that comparison were stark. Apple’s stock market value is nine times last year’s free cash flow, while Amazon’s is over 300 times cash flow. But, “sane investors would never touch a stock with such a dear valuation unless they felt cash flows were going to soar in the future,” the Times wrote. This is where the calculations become complicated; to take the comparison one step further, one must guess whether cash flows will soar in the future.
Currently, Amazon is spending a huge amount of money on new operations for its retail and data businesses. However, at some point in the not-so-distant future, the company’s spending will drop as the project nears completion and Amazon will then be able to generate much larger cash flows as its dominance in those businesses will be much more secure. But still the question remains, How good will those cash flows be?
Amazon’s operations produced $4.2 billion in cash flows last year. For the purpose of this analysis, the Times assumed generously that this metric will increase 10 percent annually, which would result in cash flows of $5.1 billion by the end of 2014. Based on an equally generous assumption that capital expenditures decrease by $1 billion from last year’s $3.8 billion, Amazon would boast free cash flows in 2014 of $4.1 billion.
Still, at this future date, Amazon’s growth in free cash flows will likely have slowed significantly and investors will probably attach a lower valuation to the company. The Times postulated that they will value its hypothetical 2014 free cash flows at 21 times, which is Google’s (NASDAQ:GOOG) current multiple. This multiple would give Amazon a market value of about $86 billion, which is 30 percent lower than it is currently.
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