Markets can stay irrational longer than you can stay solvent. — John Maynard Keynes



There are only two ways that a company can grow their pretax profits. They can either sell more products and services or increase the profitability of the goods and services which they sell. Obviously, the perfect growth company is one which consistently growths revenues while steadily increasing its operating efficiency.



Operating margins are an excellent measure of the operating efficiency of a business (so long as one-time gains are factored out). Operating margins can be easily calculated by dividing operating profit or earnings before interest and taxes (EBIT) into a companies' total revenues. Operating profit is easily accessible by examining the top of a company's income statement.



Operating profit is derived by subtracting selling, general and administrative expenses (SG&A plus research and development expenses (R&D) from the gross profit of a company. Gross profit is determined by subtracting the cost of goods sold (COGS) from the total revenues of a company.







The price to sales ratio of a company is calculated by dividing the revenues of a company into its market capitalization (outstanding shares multiplied by the current price per share).







Comparing Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN)



The following 10-year tables summarize key data from the income statements of Apple and Amazon:



AAPL



Income Statement - 10-Year Summary (in millions)





Sales EBIT Depreciation Total Net Income EPS Tax Rate (%) 09/10 65,225.0 18,540.0 932.0 14,013.0 15.15 24.42 09/09 42,905.0 12,066.0 684.0 8,235.0 9.08 31.75 09/08 37,491.0 8,947.0 460.0 6,119.0 6.78 31.61 09/07 24,578.0 5,006.0 307.0 3,495.0 3.93 30.18 09/06 19,315.0 2,818.0 225.0 1,989.0 2.27 29.42 09/05 13,931.0 1,808.0 179.0 1,328.0 1.55 26.55 09/04 8,279.0 370.0 150.0 266.0 0.34 28.11 09/03 6,207.0 92.0 113.0 68.0 0.09 26.09 09/02 5,742.0 87.0 114.0 65.0 0.09 25.29 09/01 5,363.0 -52.0 100.0 -37.0 -0.05 0.0

Sales EBIT Depreciation Total Net Income EPS Tax Rate (%) 12/10 34,204.0 1,497.0 657.0 1,152.0 2.53 23.51 12/09 24,509.0 1,161.0 432.0 902.0 2.04 21.79 12/08 19,166.0 901.0 340.0 645.0 1.49 27.41 12/07 14,835.0 660.0 271.0 476.0 1.12 27.88 12/06 10,711.0 377.0 210.0 190.0 0.45 49.6 12/05 8,490.0 428.0 118.0 333.0 0.78 22.2 12/04 6,921.12 355.87 75.66 588.45 1.39 -65.36 12/03 5,263.7 38.99 72.74 35.28 0.08 9.51 12/02 3,932.94 -150.63 81.66 -149.93 -0.4 0.0 12/01 3,122.43 -526.43 264.03 -556.75 -1.53 0.0

Avg P/E Price/ Sales Price/ Book Net Profit Margin (%) 09/10 15.10 4.14 5.60 21.5 09/09 13.30 3.86 5.19 19.2 09/08 24.00 3.09 5.11 16.3 09/07 26.50 5.55 9.21 14.2 09/06 29.20 3.50 6.59 10.3 09/05 24.10 3.27 5.98 9.5 09/04 38.80 1.74 2.88 3.2 09/03 89.80 1.21 1.80 1.1 09/02 112.80 0.93 1.29 1.1 09/01 -185.80 NA 1.39 -0.7

Avg P/E Price/ Sales Price/ Book Net Profit Margin (%) 12/10 55.20 2.40 11.83 3.4 12/09 43.00 2.43 11.36 3.7 12/08 46.80 1.16 8.21 3.4 12/07 59.80 2.65 32.20 3.2 12/06 80.40 1.56 37.90 1.8 12/05 50.90 2.37 79.73 3.9 12/04 31.40 2.72 -79.86 8.5 12/03 445.20 4.19 -20.48 0.7 12/02 -41.60 1.82 -5.42 -3.8 12/01 -7.90 1.26 -2.80 -17.8

About the author:

John Emerson I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies. I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Income Statement - 10-Year Summary (in millions)Note that in 2004 both companies had similar EBIT and AMZN had just a slightly better operating margin than AAPL (5.14% vs. 4.5%). Since that time AAPL has raised its operating margin steadily, while the operating margin for AMZN has decreased slightly. In 2010 APPL recorded a stunning operating margin of 28.4%; while the operating margin for AMZN had eroded to 4.4%.Revenues at AAPL increased by 7.78 times during the aforementioned period; as opposed to only 4.94 times at AMZN.The following tables summarize the average price to earnings and price to sales ratios for the two companies:In every metric with the exception of price to sales, AAPL appears to be a vastly superior company to AMZN. Further, a price to sales ratio is not a useful metric when viewed separately from operating margins. If price to sales alone was a meaningful metric then all a company would need to do would be to drop their prices significantly below their actual costs and watch their revenues expand.Say that Company XYZ has $20 in actual costs to produce a widget when their factories run at full capacity. Further assume that when the company sells their products at $22 per widget, they lack sufficient demand to run their factories at full capacity. Say the management decides to drop their price to $19 per widget. Quickly, maximum demand is met and the management decides to build an additional factory. At that point, management finds that they need to drop the price to $18 per widget to run the new factory at maximum capacity.The overall revenues of XYZ are now skyrocketing and their price to sales ratio for the company has dropped precipitously. It appears that "the sky is the limit" as far as widget sales so long as the company can lower their prices. However, the company is now losing $2 for every widget they are producing; such is the illogical nature of viewing price to sales without regard to operating margins.The logical question to ask is why has the share price of AMZN been increasing? Its gains in revenues are largely being offset by reduced operating margins. Although it could be argued that the company is increasing overall profits, the price to earnings growth (PEG) ratio for the company remains unfavorable.Let me take this a step further; in the time period from 2004 to 2010, AMZN increased its EBIT by roughly 420%. The cost of that profit expansion required the company to increase its depreciation expense by around 870%. During that same time, AAPL was able to increase its EBIT by approximately 5000%; however the depreciation expense for the company only increased by about 620%.Note that AMZN, a clearly inferior company, has consistently traded at a PE multiple 2 to 3 times APPL despite its much slower income growth and return on capital (ROC). APPL has a five-year trailing ROC of 28.5% versus 17.1% for AMZN.It appears that the Keynes quote at the top of the page applied in spades for investors who have held short positions in AMZN in the last decade.In the last decade both AMZN and AAPL have been stellar investments. The following chart tells the story:However, successful investing is not about past results; rather it is about future cash flows and a concept known as margin of safety. It would seem that investors in AMZN have abandoned all sensibility, particularly when the stock is compared on a head to head basis with AAPL. The only favorable valuation metric for AMZN is a substantially lower price to sales ratio and that has come at the expense of the companies' operating margin.The chart also reflects the perilous nature of shorting overpriced equities which have become market icons. Eventually the shorts will likely be rewarded but for nearly a decade the lofty valuations for AMZN have been maintained despite the companies' modest growth and flat to eroding margins.AMZN remains absurdly overpriced and investors who continue to buy and hold the stock do so at their own peril. Simply stated, the stock possesses no margin of safety. On the other hand, APPL appears to remain compelling despite trading near its all-time high. I do not hold either stock but it I had my choice I would select AAPL in a New-York minute.