This article contains some financial advice and I am not a financial advisor. You should consult a financial advisor before doing anything related to the stock market. That way if it doesn't work out, you can sue them and not me.
Jeff Bezos, the founder and CEO of Amazon, is now the third richest man in the world. His net worth is $66.8 billion dollars. His wealth skyrocketed this past year with Amazon's stock prices, which started 2015 at $312.58 a share and ended this past week at $772.56.
Compare this to Walmart, which operates in retail like Amazon, but does so in traditional ‘brick-and-mortar’ fashion. Walmart's stock was $86.27 at the beginning of 2015. It ended last week at $73.89. If you compared their market capitalization, which is total value of all of their shares on the market for each company, Amazon is worth $366.3 billion and Walmart is worth $230.3 billion.
If you went off the stock price alone, you would assume that Walmart is a lousy company and Amazon is a giant, but that is not true at all. These companies' stock performances show just how bizarre stock prices can become.
Amazon does have an impressive track record, but is it enough to make worth more than Walmart?
Amazon has 304 million active users as of 2015. It earned an impressive $107 billion in revenue last year, which is more than double what it earned five years ago. Despite all that, Amazon makes very little money. It earned $596 million after all taxes and expenses.
Wal-Mart made approximately the same profit...in two weeks.
Wal-Mart’s total revenue last year was $482.1 billion. That’s more than 4x the amount of Amazon’s. After it paid all its taxes and expenses, it earned $14.7 billion. That is nearly 25x more profit than Amazon.
For the past few years, Amazon's stock continues to sell at a higher price than what is normal. This goes against the common expectations for stocks.
The price of a stock is theoretically tied to its underlying value. The technical term for underlying value used by financial analysts is intrinsic value.
Intrinsic value is the 'actual' value of an asset that is unrelated to its market value. An easier way to understand this concept is to picture yourself buying a house. You spend $40,000 on the house with no intent of living in it. You believe that if you were to strip and bulldoze the house, you could sell the land to a developer and appliances to flea markets for $50,000.
The intrinsic, or 'true', value is $50,000, but the 'market' value is $40,000.
That is similar to how intrinsic value applies to stocks. The intrinsic value is in its profits and assets. If a company’s stock traded for higher than that value, you shouldn’t buy it and possibly even sell it if you own it because it is ‘overvalued’. If a company’s stock traded for lower than that value, you should buy it because it should go up.
In all my years of actively investing, I never found a concrete formula, ratio, or source for how to determine intrinsic value, but most professionals and investors would say it is something like - how much would a private company like this sell for to a private buyer?
Private buyers mostly care about earnings. That is why one of the most commonly used metrics for determining the underlying value of a stock is the P/E ratio (price-to-earnings).
This ratio takes the price of a stock and divides it by the total after-tax and expense profit per share of that company.
A shorter way to put it is that P/E is how many dollars do you need to spend to buy one dollar of earnings?
(You can actually find this ratio list on almost any website that shows stock data. Go to Yahoo! Finance and type in AMZN or WMT to see for yourself.)
For Amazon, you would need to spend $192.60 to buy one dollars worth of profit from Amazon. For Walmart, you would need to spend a measly $16.10 to buy one dollars worth of profit.
The theory that P/E ratios determine stock price performance seems to hold up. Historically, stocks with a lower P/E ratio (think 10-15 range) performed better because they were more bang for the buck.
That is a long-term trend though. That does not mean anything in the short term, which I think is less than five years.
In the short term, the stock of a company is really determined by supply and demand of that particular stock. If more buyers want to buy the company than there are sellers, the stock’s price will rise until it is enough to entice the owner of the stock to sell.
Amazon is a stock where few people want to sell, but a lot of people want to buy. Despite the fact that each buyer is spending $192 to buy $1 worth of earnings a year, the more analytical (and less impulsive) type of people buy Amazon believing its profits will rise to make its value worth more than Walmart.
Basically the 'smart' money buying Amazon stock think Amazon is going to be the Walmart of online retail. If any company could do that, I think it is a safe bet that Amazon could.
I personally don't think that means you should buy the stock though.
The reasonable range for a P/E ratio is 10-20. If Amazon’s share price were to remain constant, it would need to grow its profits by approximately 1100% to catch up over the next five years.
Why buy a stock that would need to remain at a constant price for its earning to catch up to what is normal?
This doesn't imply that Walmart is a good investment on its own. It simply illustrates that stock prices, even for good companies with a bright future, can be irrationally high or low at times. If you're going to buy individual stocks, it's important to look at the underlying value behind it and ask yourself - is this rational?