Understanding stock valuations can be difficult . What's more, the seemingly countless varieties of ratios don't make it any easier : price-to-earnings (P/E), price-to-sales (P/S), etc.
However, grasping these ratios is critical to understanding how expensive a stock truly is . Similarly, simply checking the share price doesn't reveal that information -- a stock trading at $2,000 could be far "cheaper" than a stock that trades at $20, depending on the underlying financial condition of the two stocks.
Accordingly, let's delve into why I think investors should consider Amazon (NASDAQ: AMZN) based on its valuation.
Image source: Getty Images.
Amazon's current valuation gives investors a tremendous opportunity
It might seem impossible, but Amazon's stock is currently making new all-time highs while also sporting a very low valuation.
So, how is that possible?
In short, it's happening because Amazon is operating at its most efficient level ever -- thanks to massive capital investments.
The company ramped up capital expenditures in response to the COVID pandemic, expanding and improving its logistics network that supports its massive e-commerce business. As it did so, the company's free cash flow dried up, as cash was funneled into construction projects, equipment, and machinery.
However, after the end of the pandemic, Amazon scaled back some projects and ended others entirely, resulting in a significant drop in capital expenditures spending and a surge in free cash flow.
Accordingly, Amazon's price-to-free-cash-flow -- a critical stock valuation metric for a mature company like Amazon -- has decreased considerably.
Amazon now sports a price-to-free-cash-flow valuation of 46x . That's down from the 400x valuation the stock had just last year.
Moreover, its current valuation by that metric is one of the lowest for the stock dating back 10 years.
AMZN Price to Free Cash Flow data by YCharts
Why Amazon can keep growing and produce more millionaires
Make no mistake: Valuation is an important metric -- but it isn't everything. For an investment to have staying power, it's important to understand what a stock's future prospects are .
Amazon's potential for growth is not limited to its e-commerce division. The company operates a diverse range of business lines, each with its own growth potential .
Amazon Web Services (AWS), the company's cloud services division, is a standout example. It now generates over $100 billion in annual revenue, a figure that surpasses most other companies. In fact, if AWS were a stand-alone entity, its annual revenue would be on par with Bank of America , Tesla , or PepsiCo .
What's more, AWS is not just a revenue generator, it's a growth engine. As organizations increase their cloud spending and the artificial intelligence (AI) revolution gains momentum, AWS is growing at an impressive rate. In the most recent quarter, AWS saw a 17% revenue growth, outpacing Amazon's overall revenue growth of 13%.
To sum up, Amazon's operations are running more smoothly than ever -- thanks to huge capital investments made during the pandemic. Moreover, the company's chief growth engine, AWS, shows no signs of stopping.
Given how much free cash flow the company is producing, Amazon's management has numerous options to create value. They could return cash to shareholders through a regular or special dividend; they could repurchase shares; they could invest in further capital spending; they could pay down debt; or they could make a strategic acquisition.
In any event, Amazon's river of free cash flow is a good reason for investors to consider the stock now.
Bank of America is an advertising partner of The Ascent, a Motley Fool company. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Jake Lerch has positions in Amazon and Tesla. The Motley Fool has positions in and recommends Amazon, Bank of America, and Tesla. The Motley Fool has a disclosure policy .
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