Amazon is worth $908 b now, and Apple, $1 t. I am not sure anyone had predicted this five or ten years before. What we should be asking now is whether it is market hype and exuberance, or has any fundamental reasoning behind it.
Value of a cash flow producing asset is the present value of its lifetime cash flows. It is very difficult to estimate how much free cash flows a business will generate during its existence. A business itself changes from its early stage as a newly incorporated, later as a high growth firm, then facing lower growth, and finally as a matured business. These changes take place due to a variety of reasons, first being the nature of business it is operating. A high tech firm will have tremendous challenges for its existence early in life. The technological change is fast-paced. Every business will have to face the macro economic factors and competition. A high profit business will attract competition. Competition will force bring down excess returns. Often, it is the quality of management that will define the course of a business. Sometimes even a poor quality business is steered by an able management, although economics of the business tend to prevail in the long run.
Market price of a publicly traded business is determined by the market forces: demand and supply. Yet, demand will be higher for a high quality business with demonstrated metrics. The market price of a good business is usually higher than that of a bad business. If for instance, the revenues, operating profits, and earnings growth are higher than its competition, the firm will be priced higher. Return on capital and equity tell us how well the capital is being employed in the business. Earnings per share are indicative of how shareholders are rewarded. The higher the growth in eps, the higher the prospects of the business.
Free cash flows generated by the firm are key to the quality of business. As noted earlier, the value of a firm is the present value of its cash flows. If we cannot estimate perpetual cash flows, at least past cash flows should be able to give us some idea about what they would look like in the next five or ten years. So there must be something to Amazon and Apple to have been priced by the market at trillion dollar levels. Let's find out their past.
amazon
Amazon had negative free cash flows for 2017. Its operating earnings were $4 b, but Amazon spends huge amounts on research and technology, which are sort of investments for future growth. However these are charged to the income statement when incurred. Similarly it spends on advertising and sales promotions, which tend to benefit the firm over the years. Amazon also has a fair amount of non-cancelable operating leases which operate like debt, but are kept off books. When we make adjustments to the income statement for these costs, we get operating earnings of almost $16 b. Suddenly we find Amazon's operating margins (9%) and return capital (28%) at pretty decent levels. In addition, the advantage Amazon is getting by charging off these costs is that its tax liability becomes lower.
Amazon had negative free cash flows for 2017. Its operating earnings were $4 b, but Amazon spends huge amounts on research and technology, which are sort of investments for future growth. However these are charged to the income statement when incurred. Similarly it spends on advertising and sales promotions, which tend to benefit the firm over the years. Amazon also has a fair amount of non-cancelable operating leases which operate like debt, but are kept off books. When we make adjustments to the income statement for these costs, we get operating earnings of almost $16 b. Suddenly we find Amazon's operating margins (9%) and return capital (28%) at pretty decent levels. In addition, the advantage Amazon is getting by charging off these costs is that its tax liability becomes lower.
However, they do not affect cash flows since these are only book adjustments. Amazon's acquisition of Whole Foods for $13 b along with its reinvestment requirements meant negative pretax cash flows of $10 b for 2017. Let's not penalize it because of one year. If we take a look at its previous ten years, we get a cumulative pretax free cash flows to firm of $20 b, or $2 b per year average. Make it previous five years, and we get $2.5 b average. If there was no acquisition in 2017, its pretax fcff would have been $3.5 b for the year. If we deduct its $10 b negative fcff of 2017 from the prior decade's total of $20 b, Amazon as a business has actually had an aggregate (2007-2017) pretax fcff of $10 b. With an effective tax rate of say, 25%, the fcff would be a total of $7.5 b during the past eleven years.
Yet the market value of Amazon's equity has increased from $42 b (high) and $ 15 b (low) in 2007 to $908 b now. Now to justify its market value, its true cash flow generating ability should be significantly higher than what it is now. Heck, we can't even take its highest fcff so far (2016) of $4.8 b aftertax, for that would mean paying 188 times. Even if we assume 25 times is a fair multiple, market's assessment of Amazon's free cash flows ability will be $36 b. How can Amazon generate $36 b of free cash flows to firm? Alternatively, market must be assuming significantly higher fcff coming in the next decade. That will be possible if Amazon's operating earnings go up, and capital spendings go down. In 2017, its capital spending was $12 b, and the five-year average was $6.3 b.
If we start with $6 b fcff, and project it go grow at 25% annually during the next decade, they will be $55 b in 2027. This is the idea: Revenues $933 b, operating margin 9%, ebit $84 b, tax rate 25%, and $8 b reinvestment will get fcff of $55 b. If we price 2027 fcff at 25 times, and calculate the present value of all cash flows at an expected return of 10%, we will have a value of $632 b for Amazon. But it is worth $908 b now, which means market has different expectations: either the cash flows or fcff multiple will have to be higher. Or perhaps the expected rate of return should change, after all ten year treasuries are currently yielding only 2.823%. Amazon is a high growth business, and growth needs reinvestment, which lowers free cash flows. Isn't the game a bit tricky?
apple
Apple had pretax fcff of $52 b in 2017, and $82 b in 2015. In the last eleven years, it generated fcff of $424 b pretax. With a tax rate of 25%, close to what it has been paying, free cash flows will be over $300 b. Compare that with less than $10 b for Amazon. If we take $60 b pretax, Apple can generate $45 b fcff at least in the near future. Of course, the growth rate for Apple is much lower than that of Amazon's. That is one reason Apple's reinvestment requirements are lower, unless of course, its aspirations for i-Car, et al are going to come alive.
If we start with $6 b fcff, and project it go grow at 25% annually during the next decade, they will be $55 b in 2027. This is the idea: Revenues $933 b, operating margin 9%, ebit $84 b, tax rate 25%, and $8 b reinvestment will get fcff of $55 b. If we price 2027 fcff at 25 times, and calculate the present value of all cash flows at an expected return of 10%, we will have a value of $632 b for Amazon. But it is worth $908 b now, which means market has different expectations: either the cash flows or fcff multiple will have to be higher. Or perhaps the expected rate of return should change, after all ten year treasuries are currently yielding only 2.823%. Amazon is a high growth business, and growth needs reinvestment, which lowers free cash flows. Isn't the game a bit tricky?
apple
Apple had pretax fcff of $52 b in 2017, and $82 b in 2015. In the last eleven years, it generated fcff of $424 b pretax. With a tax rate of 25%, close to what it has been paying, free cash flows will be over $300 b. Compare that with less than $10 b for Amazon. If we take $60 b pretax, Apple can generate $45 b fcff at least in the near future. Of course, the growth rate for Apple is much lower than that of Amazon's. That is one reason Apple's reinvestment requirements are lower, unless of course, its aspirations for i-Car, et al are going to come alive.
If we start with $45 b fcff, and project it go grow at 7% annually during the next decade, they will be $88 b in 2027. If we price 2027 fcff at 15 times, and calculate the present value of all cash flows at an expected return of 10%, we will have a value of $900 b for Apple's operating business. With net cash of $150 b, we have the market price of $1 t for its equity. The key risk for Apple is its expected growth rate. How long can iPhones shield it?
market
Different cash flows, different growth rates, different set of risks, and yet both Amazon and Apple are priced similar. The markets have reasons that reason cannot understand.
market
Different cash flows, different growth rates, different set of risks, and yet both Amazon and Apple are priced similar. The markets have reasons that reason cannot understand.
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