Do markets punish long term thinking? Amazon as a case study

This morning's New York Times has an article from one my favorite business writers, James Stewart, on Amazon. His focus, largely admiring, is on the fact that Amazon has made decisions that hurt it in the short term but create value in the long term. To provide at least two examples, he talks about Amazon's decisions to cut prices on products and go for a larger market share and to invest in in the Kindle, their book reader. The tenor of the article is that the market has short sightedly punished the company for its long term focus. Stewart uses one piece of anecdotal evidence to back up his claim that markets are short term: the stock price reaction to the earnings report on October 25, when Amazon announced earnings and revenues that were largely as expected but announced that it had been spending a great deal more than investors thought it had to deliver that growth.

I am no knee jerk defender of financial markets and accept the fact that markets not only make mistakes in assessing value, but also that a subset of investors are short term and over react to earnings announcements. In fact, I am sure that there are companies that you can point to that have been unfairly treated by markets for their long term focus (and other companies that have been unfairly rewarded for delivering short term results at the expense of long term value). I just don't think Amazon is the example I would use to bring this point on. Let's start with some general facts. Here is how the market has and is continuing to punish Amazon for its long term focus.

• In the last decade, Amazon has seen its market capitalization increase from $4.55 billion in 2001 to $82 billion in 2011; the market cap for Amazon at the peak of the dot com boom was only $30 billion. An investor who bought Amazon stock in 2001 would have generated a cumulated return of 1300% over the last 10 years. 
• In November 2011, after the earnings report that Mr. Stewart alludes to, Amazon was trading at 96 times trailing earnings and at two times trailing revenues. In contrast, the median PE ratio for a retail firm was about 15 and the median EV to revenue multiples was 0.8. By my estimate, Amazon is one of the most richly priced large retailers in the world.
• Over the last decade, the firm has made multiple bets on growth and asked the market to trust it to make the right judgments. For the most part, its actions have been welcomed by markets that have been willing to look past disappointing earnings reports at the future. Jeff Bezos is celebrated as a great CEO, with comparisons made to Steve Jobs.

So, why was the market reaction to Amazon's last earnings report so brutal? As someone who has valued Amazon almost every year since 1998, I think I can provide some historical perspective. Amazon has been, at alternate times, revered and reviled by financial markets. In January 2000, at the peak of the dot com boom, based on my estimate of value for Amazon at the time, it was over valued by about 60%. A year later, based again on my assessment of value, it was under valued by about 50%. During the 12 years that I have valued the company, it has been overvalued in 7 of the years and under valued in 5 of those years. Since the beginning of 2009, notwithstanding the reaction to the last earnings report, investors have been on their manic phase with Amazon, pushing the stock price up more than 300% (from $54 to over $200). At its price of almost $200/share, just before its October earnings report, Amazon was valued to perfection and beyond. In fact, for it to be worth $200/share, it would have to deliver about increase revenues to more than $200 billion in ten years, while increasing its pre-tax operating margin from 2.5% to 4%, while generating a return on capital of 70%+ on its new investments. If you disagree on these assumptions, feel free to change them for yourself in the attached spreadsheet.

It is the last item that I would draw your attention to, because the last earnings report was a sobering reminder that while Amazon will continue to grow, the growth is not going to be easy or cheap. In my view, the market is still much too optimistic about the quality of Amazon's growth going forward and I think it remains over priced. In Mr. Stewart's world, that would make me a short term investor, but not in mine. At the risk of repeating a theme that has run through my posts for the last few months, growth has value only if it is delivered at a reasonable cost and a growth stock is cheap only if the market price reflects that cost. Amazon does not look cheap to me, even with a great CEO and a long term focus!