I changed radio channels from the morning news to Bloomberg Radio while I was in the car yesterday. It was about 9am, so I figured I’d get some market news while avoiding the Today-like chitchat that begins on Bloomberg at 10am.
What I heard instead was an expression of disbelief about the relative valuation of AMZN and AAPL, with the former being inappropriately trading at 3x the price/free cash flow of the latter. The senior talking head presented this as being so self-evidently true as to need no further discussion.
I’m not sure why this howler bothered me, but it it did.
–Both companies were formed by visionary entrepreneurs who transformed the landscape of their industries. However, Jeff Bezos is still innovating and AAPL hasn’t produced a big new product in the past five years.
AAPL is a high-end smartphone company. Today, that’s a mature product that depends on replacement demand. There are no new customers. Network operators are trying to stretch out the replacement cycle as a way of lowering their costs.
In contrast, AMZN is all about web services, a business that’s in its infancy and growing like a weed. And the world is increasingly shifting to online purchasing.
In other words, AAPL and AMZN are very different companies.
–The accounting principles AMZN uses are more conservative than AAPL’s. What might appear on the AAPL income statement as $1 in profit might only be, say, $.75 on AMZN’s. That alone doesn’t explain why one should trade at 3x the other. But the comparison is far from clean. Dollars to donuts the talking head I heard had no idea.
–I don’t get why free cash flow generation is an appropriate metric to use in making the comparison in the first place.
Free cash flow is the money a firm generates from operations minus the capital it invests in building/maintaining the business (and, for me, minus any mandatory debt repayments, as well). Free cash flow is the “extra” that can be used to pay dividends. Good for income-oriented investors. If it’s very large, free cash flow may even attract potential acquirers in related industries who have investment opportunities that are greater than their ability to fund.
At the same time, large free cash flow can signal that a business has no new investment opportunities. So the large free cash flow may simply mean the company has gone ex growth. That’s bad. On the other hand, a firm may have little or no free cash flow because it has lots of new investment opportunities and huge capacity to grow. A growth investor will pick the second over the first any day of the week.
Personally, I don’t have a strong opinion on AMZN vs. AAPL. For years I’ve been bemused by the strength of AAPL shares despite the clear evidence that the smartphone market was nearing saturation. I’ve also been surprised by how well AMZN shares have done.
My point is that there was a children-playing-with-matches aspect to the discussion I heard. There was no recognition that AMZN and AAPL are very different kinds of companies and the comparison metric was, yes, a little more sophisticated than PE–but completely wrongly used.
Maybe CNBC isn’t so bad, after all.