Analyzing Amazon's Return on Equity (ROE) (AMZN)

Amazon.com, Inc. (NASDAQ: AMZN) is one of the very few companies with premium valuation supported by the company's continual investments, rather than ongoing earnings, which is normally used for valuation on most companies. The market assumption with Amazon is that by putting in place all the infrastructure it needs for continuous growth, the company can eventually make money, and the payoffs will be worth all the investments. Investors welcome stellar growth, but they do not easily lose sight of earnings. In the case of Amazon, many have been willing to trade earnings for growth with a less stringent view on the company's return on equity (ROE), the ultimate financial metric used by investors to evaluate their investments.

Amazon's ROE has been all but stellar, because the company isn't making enough money and it is incurring losses at times. ROE is measured as net income – the return – over total shareholders' equity. Amazon's most recent ROE, based on trailing 12-month data, stands at a mere 2.88%. The net income is calculated as the sum of the quarterly net income from the four latest quarters, and Amazon lost $57 million in one of those quarters, a drag on the ROE.

For the last five years, from 2010 to 2014, Amazon's net income has been falling off a cliff, even losing money in two of those years. In one of the remaining three years, when it did make money, net income fell by almost 80% from 2010. During the same five-year period, Amazon's investments of capital expenditures increased every year, going from $979 million in 2010 to $4.89 billion in 2014, as its cash flow statement shows. Cost allocations from capital investments must be added onto existing expenses, which reduces net income.

In the two money-losing years, there would be no reported return on equity for Amazon. In the other three years, ROE was 16.78% at the beginning of the five-year stretch, 8.13% the next year and 2.81% a year later, gradually decreasing as the company's capital investments intensified. Meanwhile, Amazon stock ended trading higher at the close of each year than what was at the beginning of the year, except in 2014. So far in 2015, the stock has been trending higher, more than doubling its closing price for 2014. While Amazon investors have not seen much return from equity-enabled earnings, they have certainly witnessed stellar return from price appreciation of the stock.

Since no companies invest the way Amazon does, sacrificing current earnings for continued growth and future payoffs, it is likely that in the near term, Amazon's peers would have better ROE than Amazon itself unless they encounter serious business and financial issues. Wal-Mart Stores, a close competitor of Amazon, maintained its investments of capital expenditures very much flat from 2010 to 2014, weighing less on its net income. On a trailing 12-month basis, Wal-Mart's ROE is 19.78%, dwarfing Amazon's 2.88%. However, Amazon's heavy investments are meant to contribute to increasing shareholders' equity in the longer term. With a larger equity base comes a stronger earnings-generating ability. When earnings growth surpasses the rate of equity accumulation, there would be higher ROE.

Amazon is in the diversified retail industry, which consists of Walmart and other retailers, such as Target, Macy's and Costco. The five-year average ROE for companies having at least $15 billion in market capitalization is mostly in the high teens percentage-wise, which is the case for Walmart, too. Macy's, however, has an ROE of 22.41%, partly the result of being a more profitable company than the others. Profitability does play a role in projecting a company's ROE and may explain any potential ROE variations. Amazon has the strongest revenue growth, with a rate of five-year average almost at 30%. Trying to rein in other costs to counter the early unfavorable investment effect may help Amazon improve its ROE over time before its investments take their full positive effects in the future.