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Amazon has a lot to prove to justify its surging stock price

Amazon Inc., stoked by announcements of new movie-streaming deals and an updated Kindle device, is hitting all-time highs.

Even more impressive, in a way, is its price-to-earnings ratio: 300 times trailing earnings, roughly 160 times forward earnings. Impressively expensive for a company that's been public for 15 years and has more than $50-billion in sales.

To understand the P/E, however, requires understanding that Amazon's earnings are remarkably small, on purpose. The company is spending aggressively and accepting low margins in the name of long-term growth.

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Here's the remarkable fact: Amazon's net income margin in the second quarter, ended in June, was 0.1 per cent. It has been at or below 1 per cent in each of the last four quarters.

For perspective: There are 394 companies in the S&P 500 that have posted net income in each of the last four quarters, per a search on Standard & Poor's CapitalIQ. Just three, including Amazon, have a net income margin below 1 per cent over the last year. (Drug distributors Cardinal Health Inc. and AmeriSource Bergen Corp. are the other two.)

The teeny-tiny net means Amazon is one of just two S&P 500 companies with both a trailing and forward P/E over 100, per CapitalIQ's measurement. (Industrial REIT Prologis Inc. is the other.)

And it also means you have to look to a measure of price-to-sales – as if Amazon was an unprofitable startup – to get a reasonable valuation for the company.

Amazon's enterprise value – market capitalization plus net debt – is about 1.55 times its forward revenue. There are 281 companies in the S&P 500 with a richer number, per CapitalIQ.

Of what can investors dream if all Amazon's growth-oriented high spending pays off? Well, its all-time best net income margin for a full calendar year came in 2004, when it posted a figure of 8.5 per cent. (The second-best was 4.2 per cent in 2005.)

According to CapitalIQ, current expectations for Amazon's 2014 revenue are just over $100-billion, nearly double what the company posted in the 12 months ended June 30. Even then, however, the expectation is for about $2.2– billion in profit, or a net margin of around 2 per cent.

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Perhaps in 2016, Amazon can post $150-billion in sales and return to an 8.5 per cent profit margin, yielding more than $12-billion in profit and making the current market value of roughly $117-billion look reasonable.

That, however, represents an already-huge company tripling its sales in five years and returning to levels of profitability it's only come close to once in its long history.

It seems buying Amazon shares at these levels is just as aggressive a bet as Amazon management is making on its future.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More

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