Why Do Some Tech Companies Play by Their Own Rules?

Joel Anderson  |

Online retail giant Amazon (AMZN) released its earnings last week. And they posted a loss. Just as was expected, Amazon lost $0.09 a share in Q3 of 2013. And, as one would expect, the next day share...bounced by almost 9.5 percent. For any number of CEOs out there, this has got to be frustrating. The company loses money, it was expected to lose money, and yet the share price soars even higher. With a share price just short of $360, the stock currently sports a P/E ratio north of 1,200. No, that's not a typo, it's well over 1,000.

So how does Amazon still have so many investors fawning after them? Why are investors willing to pay $1,200 for one dollar of earnings at Amazon while other, wildly successful companies are trading for so much less. The short answer would be that the company's growing rapidly. Amazon's $17 billion in net sales represents a year-over-year gain of nearly 25 percent. It's clear to most market observers that brick-and-mortar retailers are on the decline and that Amazon is the future of retail. Any money Amazon is making, it's reinvesting into expanding. To borrow from Breaking Bad, Amazon is in the "empire building business."

Investors Ready to Endure

Amazon may show tremendous potential, but is that really enough to make Amazon worth what shares are selling at? Even if they're en route to becoming the next Wal-Mart (WMT) , at what point is the company worth this kind of money? A quick look at Wal-Mart, a company whose last reported quarter posted over $115 billion in revenue, shows a P/E ratio of about 15. Amazon's currently sitting at 80 times that. So at what point can we expect Amazon to start making 80 times what it is now? Because until that point, one could argue that Wal-Mart's clearly the better buy.

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So, essentially, investors are willing to take abuse from Amazon, foregoing any actual profits as the company expands rapidly.  But why is that the case for Amazon and not for Wal-Mart? Why are Amazon's hypothetical future earnings worth more than Wal-Mart's present, very real earnings? What would one expect to happen to Wal-Mart's stock if it announced that it was going to start reinvesting all its profits into expansion for the next few years? One might anticipate something of a luke warm reaction from the markets.

Amazon's Not Alone

Amazon's not the only company that's trading at a hefty premium because people are anticipating success. It seems as though there's nothing more valuable to investors than a big idea. Just look at Tesla (TSLA) , an auto company that can make 20,000 cars a year, is worth almost $20 billion, and sports a P/E ratio of...well, that's hard to say exactly because the company has yet to make any money. Compared with those two, Netflix (NFLX) and its P/E ratio north of 275 is a steal.

Unknown Futures Mean Different Rules

So why do some of these tech companies seem to play by their own rules? Why do their stocks trade at massive valuations that, even with the sunniest of outlooks, they probably won't live up to for at least a decade? Can they really be worth that? The short answer would be yes. If the simple reason that a company's stock is worth what anyone's willing to pay for it. And as long as the market is enamored enough with the business plans driving these companies, their valuations are right.

The longer answer is that part of the reason these companies are trading at these massive prices is because they're valuation depends on bigger question marks than businesses like Wal-Mart. Obviously, no one can see the future, but the future for online retail is much murkier than the others. While one might scoff at the idea that Amazon's ever going to make enough money to be worth what it's trading at, it's also pretty hard to be sure that it won't. The rapid shift to online retail is happening quickly, and precisely what portion of the market it's going to hold in the future is totally uncertain. The same can be said for luxury electric cars or streaming media. The products are new enough, and have enough potential, that no one can be certain just how valuable they really are.

And, for the time being, enough people are ready to pay a premium for these companies with ideas that are way bigger than their earnings. And only time can tell who's right.

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