Discounted Cash Flow (DCF) models can be a fantastic resource for investors trying to calculate the intrinsic value of a company. They have clear input parameters and by unlevering these cash flows, DCF models fairly compare any two companies- something that other metrics can miss when comparing different industries. That said, DCF models are not always a perfect fit. Some companies operate in such a way that the DCF results do not accurately reflect the true value of the company.
Amazon, one of the top 5 largest companies in the world, provides possibly the best example of a common pitfall with DCF models. As of this writing, Amazon is valued at roughly $1.6 trillion, yet DCF Tool gives the following results:
7 out of the past 9 years have negative cash flows, yet the company has reported massive growth in earnings year over year for nearly a decade of around 25-35%. Revenues have grown to almost $500 billion in 2021, yet DCF Tool models the stock as having a negative value.
Something very important to know about Amazon is their company approach, which looks different from many other companies. In simple terms, Amazon invests heavily in the company to drive growth, which increases revenues, which they then reinvest back into more investment in the company to drive more growth.
Every company uses this model to some extent to drive growth. Amazon however does this at a much higher level, with investments increasing with their revenue growth. Their historical financial statements indicate that year after year they spend significant amounts of money on reinvesting in growing.
These investments can be seen under the “Capital Expenditures” line of a company’s financial statement, representing cash spent towards the company. These expenses cover a variety of items, but can be generally seen as investing in the business model or it’s growth.
To put in perspective just how much more Amazon spends on this than other companies, below is a graph of the ratio of capital expenditures to earnings before interest and taxes (EBIT). This ratio normalizes a company’s CapEx spending relative to how much money they earn.
All of these companies are trillion dollar companies with established earnings, with 3 of the 4 being in the technology sector. While Apple, Walmart and Google are all within the same range year to year, Amazon blows the other three away in capital expenditures.
The other significant result is how Amazon’s ratio exceeds 100%, as indicated by the red line. It’s not just that Amazon spends more that affects DCF results, the fact this is more than EBIT significantly skews results.
The basic equation for Unlevered Free Cash Flows (UFCF) is:
$$UFCF = EBIT * (1 - Tax Rate) + D\&A + \Delta NWC - CAPEX$$
EBIT is the main driver for creating positive cash flows for a company and capital expenditures are taken away. Conceptually this makes sense, “free cash flow” related to how much a company earns minus anything it spends on business operations.
The key for Amazon is that because CapEx exceeds EBIT (in 2017 it was nearly 300% of EBIT) the UFCF result is almost always negative. For every dollar they earn, they spend more on reinvesting in the company. This creates a negative cash flow condition. As DCF models rely exclusively on this result, Amazon results in an entirely skewed result that is not applicable.
Traditional DCF models provide insightful results to valuing a company, however there will always exist extreme examples where DCF models breakdown. Amazon provides the largest and best example. In these situations, look to other metrics for evaluating the investment proposition in lieu of DCF models.