Amazon has beaten or knocked out nearly every heavyweight retail contender.  Those still in the bookstore business (R.I.P. Borders) keep getting uppercuts to the chin. Investors in Amazon’s stock have made a fortune.  In the past 10 years, shareholders have gained nearly 720 percent.

Yet the company stands on wobbly legs.  That might sound crazy.  Amazon sells a lot of stuff.  But it barely makes money.

-In their second quarter of 2014, Amazon lost $126 million.

-Profits were 54 percent lower in 2013 than they were a decade previous.

-Average annual net income between 2004 and 2006 was $379 million.
  Between 2011 and 2013 it was $288 million.

 No matter how you slice it, Amazon’s a dog in the earnings department. So why has the stock soared?

Stocks rise when there are more buyers than sellers.  Amazon has a big fan base. But should you buy a stock just because its price rises?  Warren Buffett says no. He once said, “The dumbest reason in the world to buy a stock is because it's going up."

If you want to pick stocks he says, "Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

Company profits and share prices are joined at the hip.  Sometimes, a company’s share price rises faster than business earnings.  Sometimes, it’s the other way round. But long term, there’s no breaking the alignment between share prices and company profits. Stocks that rise far faster than company profits face one of two scenarios:

  • Their prices plunge

Or

  • Their prices stagnate…sometimes for years

This doesn’t mean, however, that Amazon’s shareholders are destined to lose money.  Nor does it mean they’ll necessarily make paltry future returns.  Shareholders could keep getting richer.  But the company’s profits would need to rise faster than a revolution.  Currently, its trailing PE ratio is 827 times earnings.  This means that it would take 827 years for Amazon to buy back every one of its shares, based on its current market price, and based on its 2013 profits.  You probably don’t want to wait that long.  In contrast, it would take Apple Inc. fewer than 17 years. 

But why doesn’t Amazon make money?  For one, their profit margins are slim.  The typical retailer, for example, might buy a widget for 50 cents, but sell it for a dollar.  Amazon might pay 50 cents for the same item, but sell it for 60 cents.  Such a practice kills the competition.  But as Amazon may have proven, it isn’t a way to make money.

If you’re thinking of buying individual stocks, consider Buffett’s mantra.  Select stocks at rational prices.  Buy those whose earnings are nearly certain to rise over time.  Avoid stocks whose prices have ripped ahead of business profits.  Instead, consider the opposite. Companies whose profits have risen faster than their share prices eventually have their days in the sun.

Amazon may be the world’s biggest retailer.  But unless it starts punching above its weight, the stock will be ripe for a knockdown.

Comparative Business Profit Growth Versus Stock Price Growth

Stock Total 10 Year Business Earnings Growth Total 10 Year Stock Price Gain
Amazon -54% +720%
Cisco Systems +36% +33%
Microsoft +80% +68%
Coca Cola +77% +108%
Johnson & Johnson +62% +89%
Nike +122% +309%
Pfizer +93% -1.8%
Medtronic +69% +24%
Wells Fargo +197% +77%
Table Legend

Stock price growth has dramatically exceeded earnings growth
Stock price growth has dramatically lagged earnings growth