While the technology giants have challenged and transformed the multitude of industries in which they operate, they are now challenging the traditional methods of stock valuation. Amazon, for example, has changed both consumer and competitor behaviour. The business may appear overvalued according to the standard metrics, but its outlook is bright.
Over the last two decades, certain technology companies have transformed the way that consumers and companies behave, growing into spectacular behemoths in the process. According to historic metrics like P/B these companies look vastly overpriced, yet it would appear that their monopolies and growth prospects represent valuable investment opportunities.
Six degrees of transformation
Amazon is a clear example of this paradox. The company has changed the way we live in many ways: the Kindle impacted our reading habits, Prime service altered the way we shop, and the Echo has started to change the way we manage our homes. Amazon has also challenged accepted business practices by offering a retail platform for small third-party suppliers, and by creating a new standard in logistics execution. The breadth of Amazon’s operations means it cannot simply be considered a retail business: it is now a global leader in a number of industry sectors.
Adapting to the environment
This multi-faceted business model allows Amazon to continuously innovate, providing strong future growth prospects. Instead of emphasising earnings, the business has pursued revenue growth and significant re-investment in order to consolidate its market positions. This approach has been largely successful. Amazon’s management has exhibited superior execution skills, investing in new business segments and often defeating competition from new contenders.
While there have inevitably been some mistakes along the way, (such as the Fire Phone, which lost over $170m), the sheer scale of the company means these have been absorbed relatively painlessly. All of these factors combine to create expected annual revenue growth of roughly 20 per cent, a healthy balance sheet, and phenomenal market sentiment.
Although Amazon has unquestionably been successful, the management’s decision to pursue this model has impacted the business’ backward-looking metrics. As previously stated, traditional measures like P/B ratio make Amazon look very expensive, but these analyses fail to take into account its future growth potential.
In order to fully account for potential growth in a company’s valuation, it is necessary therefore to value Amazon and similar businesses using our ‘hyper-growth’ model. This model allows us to place greater emphasis on forward expectations and market sentiment, and thus more accurately track the likely direction of a business’ share price. Amazon is a textbook example of when applying the ‘hyper-growth’ model achieves a more realistic valuation.
Geir Lode is head of global equities at Hermes Investment Management