Knowing which valuation model to use for financial analysis can be incredibly confusing for even the most seasoned of investors. For example, my discounted cash flow (DCF) model tells me that Amazoncom Inc.’s (NASDAQ:AMZN) is overvalued by 114.15%, but my relative valuation tells me it’s overvalued by 85.1%. So, which valuation methodology should I listen to and why?
See our latest analysis for Amazon.comExamining intrinsic valuation
At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. Calculating the per share intrinsic value of AMZN involves two key steps. First, I discount the sum of AMZN’s future FCFs at 13.52%, which gives us an equity value of $330.68B. After dividing this by 484.97M shares outstanding, we get a target share price of $681.86. This means that broker analysts think AMZN is currently trading above its true value at $1460.17. Take a look at how I arrived at this intrinsic value here.,
But how accurate is this figure? Since our analysis relies on quality FCF forecasts, let’s see how many analyst forecasts we have by the final year of AMZN’s 5-year forecast horizon. Given there are only 3 analyst projections of AMZN’s FCF in year 5, our model highlights that it is often really difficult to accurately forecast FCFs that far out into the future. Ultimately, not having enough forecasts for the final year weakens the conclusions our DCF draws on AMZN, which means we may want to put less significance on our model when determining a target price.
A closer look at relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to AMZN, a viable proxy would be the overall Online Retail industry itself. The calculations for relative valuation are quite simple. By multiplying AMZN’s earnings by the industry’s P/E ratio, we can obtain AMZN’s fair value of $217.52, which tells us that it is overvalued. However, should we believe this result?
One quick way of finding out is to see if AMZN shares a similar growth profile to the overall Online Retail industry we are comparing it to. With a projected earnings growth rate of 31.84% for next year, AMZN has a significantly different growth profile when compared with the Online Retail industry, which is projected to grow at 25.1%. This demonstrates that the Online Retail industry is a weak proxy for AMZN, which undermines our relative valuation analysis. Rather, selectively choosing companies that had similar growth characteristics to AMZN would vastly improve our conclusion. I’d encourage you to do this by taking a look at AMZN’s competitors.
Which Model Should I Care About?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. While intrinsic valuation is immune from market irrationality and mispricing, it is highly exposed to forecasting error. On the other hand, relative valuation is easy to calculate but affected by overall market mispricing. For example, relative valuation would not have been an effective tool to value a technology company at the height of the dotcom bubble in 2000. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
Next Steps:
For AMZN, there are three relevant aspects you should further research:
- Financial Health: Does AMZN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does AMZN’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of AMZN? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.