Case study : Amazon
What is the business model for Amazon.com? How does their business model differ from that of Barnes and Noble or Borders? How would you value Amazon.com?
Amazon is a relatively small player in the bookstore industry, and its main competitors are Barnes & Noble and Borders. Despite the difference in scale, the company shows great promise, because its business model overcomes many of the competitors’ drawbacks.
Amazon operates using a web-based platform to sell books. The web-based model targets a global market, has reduced overhead costs and a shorter operating cycle as compared to brick and mortar businesses such as Barnes & Noble and Borders. Amazon’s online model has a superior inventory management system, low occupancy cost and high sales per employee. Amazon can reach large, global groups of consumers with minimal cost, which make the business model very scalable .
Another fundamental of the company is its distinctive, lean operating cycle. The average payables time is 58 days after a book enters inventory. However, due to the very fast inventory turnover, the average receivables is 17 days after a book enters inventory. The difference leads to a 41-day gap between payables and receivables. Such a long cycle allows large cash reserves and profitability in any business, and all the more so in the bookstore industry. Traditional brick and mortar bookstores have a negative cycle, where payables are executed 90 days after entering inventory, but average receivables come in at 168 days after entering inventory. Thus, a -78 days gap exists between receivables and payables, draining cash from the company. The faster payables period (58 vs 90 days) is also a competitive advantage for Amazon relative to publishers and other suppliers.
Opposite to this business model we find the traditional bookstores. They have the advantage to be well known and established in the market. On the downside, bookstores like B&N or Borders need significant capital resources in inventory, real estate and personnel to function. Their business model is not only very costly, but also limiting with regards to customizing the individual shopping experience for each customer.
There are three ways to value Amazon. A first approach is to perform a perpetuity discounted cash flow analysis. Free cash flow can be projected by first examining a growth rate for the firm that we applied to sales, and another that we applied to operating costs with ultimately a perpetuity growth rate of 5%. We assumed that cost of goods sold would stay at 70% of sales and that the NWC would be -5% of the sales as the operating cash cycle is negative.
The second approach is to rely on price/earning ratios of comparable companies, as listed in Exhibit 13 in the case. Comparable should include mainly Internet content websites, but also the retail bookstores. Amazon has a much more profitable cash cycle, and therefore its revenue multiplier should be above traditional bookstore chains. Since Amazon has a tangible commerce model, its multiplier should also be higher than the online search websites. However, since its traffic is far lower than Yahoo, it would not be able to command such an inflated multiplier. 4x to 5x is probably a good value, giving Amazon a value of $250M to $300M in 1997 based on an estimated $64M of revenue.
The third approach is to use the implicit valuation given by the private investors. In March 1997, there were 17.3 M common shares outstanding. The final investment in February 1997 at $6.66/share implicitly values Amazon at $115M. With those three approaches, we can estimate Amazon.com value being in a range between $115M (using February 1997 valuation) and $303M when using the discounted cash flow method. As the price/earning ratio gave us a $250M to $300M valuation, we can estimate the fair value of Amazon.com between $280M and $300M. With 23,298,781 shares outstanding after the IPO, a fair...
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