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Question Description

Case Study: Amazon.com

As a financial manager, you are thinking of investing in the US equity market. To avoid the hassle of making a portfolio and the commissions of mutual funds or ETFs, you plan to purchase a single blue-chip stock and hold it. You are targeting on Amazon’s stock. As Amazon.com Inc. does not pay dividend at all, you will not be able to use dividend discount model (DDM). Therefore, you will be determining prices based on both the discounted free cash flow (FCF) valuation method and the comparable P/E ratio method. You are a little concerned about these two methods because your finance professor explained that these two valuation methods can result in widely differing estimates when applied to real data. You are hoping the two methods will give similar prices.

  • Go to https://www.reuters.com/ and enter the symbol for Amazon (AMZN) in the “Search” box, then select Amazon.com Inc. From “Key Metrics” and “Financials” for AMZN, gather the following information, and enter it into the Excel template:
    • The current stock price
    • The EPS (TTM)
    • The number of shares of stock outstanding
    • The Revenue Growth Rate (5Y)
  • To find the industry P/E ratio. Go to https://finviz.com/ and click on “Groups”. Then select “Industry (Consumer Cyclical)” from the drop down menu under “Group”. Find the P/E for Internet Retail industry and enter it into the spreadsheet.
  • Go to http://www.morningstar.com and enter “AMZN” into the “Quote” box. Under “Financials,” Click Income Statement. Copy and paste (or use the Export to Excel button to create a new file with the data) the most recent three years’ worth of income statements into a new worksheet in your existing Excel file. Repeat this process for both the balance sheet and the cash flow statement for Amazon. Keep all of the different statements in the same Excel worksheet. Note: Make sure you are collecting annual data, rather than quarterly or interim data.
  • To determine the stock value based on the discounted free cash flow (FCF) method:
    • Forecast the free cash flows. Start by using the historical data from the financial statements downloaded from Morningstar to compute the three-year average of the following ratios:
      • EBIT/sales
      • Tax rate (income tax expense/pretax income)
      • (Gross) Property plant and equipment/sales
      • Depreciation/property plant and equipment
      • Net working capital/sales
    • Create an empty timeline for the next five years.
    • Forecast future sales based on the most recent year’s total revenue growing at the revenue growth rate from Reuters for the first five years.
    • Use the average ratios computed in part (a) to forecast EBIT, property, plant and equipment, depreciation, and net working capital for the next five years.
    • Forecast the free cash flow for the next five years.
    • Determine the terminal enterprise value for year 5 using the equation on slide #32 and a long-run growth rate of 9% and a cost of capital for AMZN of 11%.
    • Determine the enterprise value of the firm as the present value of the free cash flows.
    • Determine the stock price using the equation on slide #33.
  • To calculate an estimate of AMZN price based on a comparable P/E ratio, multiply the industry average P/E ratio by AMZN EPS.
  • Compare the stock prices produced by the two methods to the actual stock price. Why do these estimates differ from the actual stock price of AMZN? Should you buy AMZN stock based on your price estimates?