Advanced discounted cash flow valuation of Amazon

Jan 254 min read

I have been valuing companies for 20 years already and was frequently frustrated with the shortfalls of standard discounted cash flow (DCF) models. Now I have put together all my experience and ideas into a single model, which I call the advanced DCF model, and tried and tested it on the valuation of some of the most popular participants of the S&P 500 index. In this blog, we are covering Amazon.

How did I modify traditional DCF valuation models to create an advanced DCF model, and for what reasons?

It measures the value of a company in all explicit periods of projection, not only in period zero, so it is dynamic valuation. Value is not static, and major investments or share repurchases in period 1 can alter the valuation of a company in period 2 in a way that might surprise you. In this template, you can understand these impacts better.
One of the most important changes is, in addition to the abovementioned dynamic valuation in future periods, I introduce retrospective valuation in a historical 4-year period. This immensely improves the accuracy of projections going forward, as it gives transparency on what assumptions on ROIC, discount rate, and growth the market applied to the company, and helps to triangulate whether these assumptions support assumptions for future years. By benchmarking with many other comparable companies, you can easily get a sense of the appropriate ROIC, discount rate, and growth. I always missed that in standard DCF models and find it very useful in my valuations.
It values a company using two universally accepted DCF methods and reconciles them so they are aligned - Free cash flow to equity (FCFE) and Free cash flow to firm (FCFF).
It introduces a controlling mechanism by using return on invested capital (ROIC) to project EBIT in P&L, so we bring this core driver of value into action instead of keeping it hidden as most valuation models do. You will come to appreciate that return on invested capital is one of three key drivers of value, together with growth rate and cost of capital, and the majority of valuation models we see in practice do not even measure it.
It explicitly presents how total shareholder returns (TRS) reconcile with the cost of capital, both on the cost of equity level and WACC level. Furthermore, it slices and dices TRS for sources of growth to measure what part is organic growth, which part is due to retaining excess cash in the business, and what part comes from share repurchases or dividends. This allows us to explicitly link dividend distribution policy with projected TRS.
It builds a projected balance sheet as well, which is a great way to understand the completeness, accuracy, and reasonableness of projections, which is often omitted in classic valuation models.
It uses dynamic cost of capital so you can vary its assumptions across periods, which is what really happens in real life as risk-free changes as monetary policy can dramatically change in the period of 10 years.
It expands the projection period from the standard 5 years to 10 years to be able to understand how dynamic valuation changes as assumptions change.
It brings to light which debt assumptions are implied within the weighted average cost of capital, so you can better understand debt level and cash flow from debt, and plan capital structure for a new company.
It calculates valuation multiples (EV/S, EV/EBITDA, EV/EBIT, P/E, P/B) in two ways, first via simple calculation based on DCF outcome, and second by direct formula which calculates a valuation multiple by plugging in directly growth rate, margin assumption, discount rates, return on equity or invested capital, and tax rates. This helps triangulate the reasonableness of assumptions and shines light on the appropriateness of valuation.

Now let's look at the application of the model on the Amazon case. Summary assumptions are:

Assumptions for business valuation of Amazon

Impressive sales growth with double-digit increase in most years since 2019 until 2023, and expected to average at 6% going forward
Stable and ever-increasing gross margins expected to range at 16%, EBIT margin at 7%
EBIT more than doubles since 2019 until 2023
Relatively moderate level of debt to book value of assets and equity, but only 8% versus market value of equity
Almost no net working capital as inventories plus receivables are offset by payables
Stable return on invested capital, in the range from 14 - 29% over the last 4 years with an outlier at 4% in 2022, while expected going forward at 13%
Weighted average cost of equity expected to range 7-9% in the forecast period
Zero dividend and share repurchases are expected, so reinvesting all cash in the business
Significant CAPEX as % of operating cash flow, but still generating stable free cash flow
Sales to invested capital 2.4x, and NOPAT as % of sales 5%

Result

As of valuation date 31.12.2024, fair market value of enterprise value is estimated at 2,013 USDbn, market value of equity at 1,877 USDbn, which with cash and financial assets amounts to 1,964 bn. On a per share value, this amounts to 187 USD per share which given actual share price of 152 means valuation is 5.3% higher than traded share price.

Advanced discounted cash flow valuation of Amazon enables observation of valuation for a 4-year historical period and a 10-year projected period as well, not only "valuation date" 31.12.2024.

Advanced discounted cash flow valuation model (DCF)

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