Late last month, Amazon.com (NASDAQ: AMZN) released a stellar third-quarter earnings report. Sales skyrocketed 34% year over year to $43.7 billion. (The increase would have been 29% excluding Amazon's acquisition of Whole Foods and exchange rate changes.) Earnings per share also came in way ahead of analysts' estimates.
Continue Reading Below
Amazon stock surged following the earnings report, and it has been trading for around $1,100 ever since. This gives the company an astounding market capitalization of roughly $550 billion. Unfortunately, it will be extremely difficult for Amazon to live up to that valuation without running afoul of antitrust regulators in the not-so-distant future.
Amazon.com is primed for huge revenue and earnings growth
Many Amazon bears point to the company's extraordinarily high earnings multiple as evidence that the stock is too expensive. As of the end of the day on Thursday, Amazon stock traded for 258 times the average analyst estimate of its 2017 EPS. Bulls counter that Amazon.com has enormous opportunities to grow its revenue and improve its profit margin in the years ahead.
Based on Amazon's track record, it's hard to dispute the latter point. Revenue has nearly tripled in the last five years alone. Despite the company's massive size, there is no sign that its revenue growth rate is slowing yet.
Meanwhile, it's widely understood that Amazon reinvests virtually all of its profit to drive further growth -- e.g., by moving into new markets and speeding up shipping times. Once the pace of investment moderates, Amazon's profitability should improve dramatically.
Continue Reading Below
Amazon will need to reach a massive market cap to be a good bet
While Amazon stock deserves to trade at an extremely high earnings multiple, investors may not fully appreciate how valuable the company will have to become to reward investors who buy at the current price.
Amazon is unique among the most valuable U.S. companies in that it doesn't return any cash to shareholders and has no prospect of doing so anytime soon. Apple (NASDAQ: AAPL) now has a market cap of roughly $900 billion, but for the past four years, it has returned $47 billion a year to its shareholders, on average. As a result, investing in Apple stock can pay off for investors even if Apple's market cap rises at a relatively modest rate.
By contrast, Amazon has actually been diluting shareholders for the past several years by issuing stock to its employees while not repurchasing any shares. As a result, Amazon's share count has been increasing by a little more than 1% each year, causing its market cap to rise even faster than its stock price.
Including employee stock awards, Amazon currently has roughly 500 million shares outstanding. Let's assume that it will also have 500 million shares 20 years from now. This seems reasonable, as Amazon's ongoing investment spree will probably cause the share count to continue rising for the next decade, but the company may be able to resume buying back stock thereafter.
If Amazon stock appreciates at a solid (but not spectacular) annual rate of 10% over the next 20 years, the company's market cap would reach $3.7 trillion based on a share count of 500 million. That could be hard to achieve, even for Amazon.
Slowing growth isn't the only risk
Amazon will be a fairly mature company 20 years from now, so it will command a much lower earnings multiple. At 25 times earnings, and assuming a 20% tax rate, Amazon would need to be earning $185 billion before tax in 2037 to command a $3.7 trillion market cap.
As a result, even if Amazon investors avoid the pitfall of a sharp slowdown in growth, they will face the very real risk of an antitrust crackdown against the company. Amazon already has a lot of market power. It will have a lot more market power under any scenario where it is making $185 billion a year, whether that's $1 trillion of revenue and an 18.5% pretax margin or $3 trillion of revenue and a 6.2% pretax margin.
Wal-Mart has periodically faced calls from consumer advocates for its breakup, although it has managed to stave off that threat. However, it still has less than $500 billion of annual revenue and a pretax margin of around 5%. To grow into its valuation, Amazon will need to become far larger than Wal-Mart and far more profitable, to boot.
Maybe antitrust regulators will remain asleep at the wheel. However, that's not a risk I'm willing to take as an investor. It will be hard for Amazon to become big and profitable enough to pay off for long-term investors without becoming so big that it triggers damaging antitrust scrutiny.
10 stocks we like better than Amazon
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Amazon wasn't one of them! That's right -- they think these 10 stocks are even better buys.
Click here to learn about these picks!
*Stock Advisor returns as of October 9, 2017
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg owns shares of Apple and is long January 2018 $90 calls on Apple, short January 2018 $140 calls on Apple, and short February 2018 $160 calls on Apple. The Motley Fool owns shares of and recommends Amazon and Apple. The Motley Fool is long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.