In the 2000s, most investors struggled to value Amazon*. For the 10 years between 1999 and 2009, the tech company grew its revenues while building stronger barriers to entry as it focused on customers and their experience first. It duly expanded from selling books online not just to selling everything online, but to other businesses like Amazon Web Services too.
Yet for all the company delivered to its customers, it never delivered positive earnings or cash flows to investors during that period. For a decade, Amazon’s shares largely underperformed the market and provided its investors with scant returns.
Fast forward to 2020: Amazon is making $21 billion in net profits and $70 billion in earnings before interest and taxes, is throwing out over $30 billion of cash every year, and its shares are up by 6,500% since 2009. Amazon has changed the landscape of commerce and taken market share from traditional retailers by disrupting the industry.
There are many examples of similar stories, of start-ups becoming giants and generating significant revenues and profits – Netflix*, Facebook*, and Google* to name a few. The rate of disruption in the S&P 500 is becoming faster and more aggressive than ever. The average number of years a company remains in that index has come down from 30 to 14. COVID-19 and lockdowns have accelerated even more of this disruption by forcing industries to change fundamentally.
Looking for a whale
Investors have seen the Amazon story. Whether they have benefitted from it or missed it, many are looking for the next big thing. No longer do investors wait for earnings to be delivered before recognising the value in shares; they start to ascribe value today.
Finance theory teaches us that the market capitalisation of a company is the present value of the future stream of its cash flows or earnings. If that stream of earnings starts tomorrow or 20 years from now, should it really matter? It arguably affects the discounted value, but then again what is the certainty or predictability of legacy companies delivering the same or higher earnings in 20 years’ time given the disruption risk they face?
The other argument some make about companies with high growth potential is that they are “too expensive”. This is typically in reference to one-year forward price-to-earnings ratios or free cash flow yields. It’s a fair point. But take the “average” company – not that such a thing exists – trading at the market multiple of 21 times earnings. This implies that over 96% of its value comes from its future earnings stream (1 minus 1/21) and a decent portion from the concept of “terminal value”.
Given the pace of disruption and ability of successful companies to deliver unique products to large addressable markets, would you wait until such a company trades at 21 times earnings or would you ascribe its future market capitalisation today?
Some would say that this theory only works in a low interest-rate environment. I would acknowledge that to be true. However, with global rates likely to be range bound until the global economy emerges from the crisis, we don’t see US 10-year yields going much above 3% for an extended period of time. Moving the discount rate from 7% to 9% therefore changes the value of a company by only 30%.
There are many industries going through transformational changes – enterprise workloads, the energy transition, advertising, payments, and electric vehicles among others – similar to those that gave rise to Amazon.
Yet one caveat to the optimism about the associated growth potential is that markets can tend to give all companies involved the benefit of the doubt, which they don’t always deserve. Remember eBay, AOL and BlackBerry?
Not all trees grow to the sky. Not all companies have the right management teams to take them through the most challenging periods or re-orientate them to more sustainable and long-term business models.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.