There are indications that AI-enthusiasm is leading current stock market valuations to be driven by sentiment, the psychological biases of excessive optimism and overconfidence, rather than by fundamentals.
Four of the largest U.S. companies engaged in AI have announced plans to increase their capital investment by 45%, a testament to their great optimism for the technology. The four companies are Amazon, Alphabet, Microsoft, and Meta. Of these, Amazon’s share of the planned increase in capex is the largest, at almost one third. At the same time, U.S. stocks have held fairly steady, although the S&P 500 has declined by about 3% since the January 20 inauguration of President Trump.
Analysts Estimate Fundamental Value Of Amazon
The case of Amazon provides a good vehicle for assessing the degree to which stock prices reflect psychological biases rather than underlying fundamentals. The fundamental value of the company as a whole is based on the amount of cash a company generates during a period of time which is available to be paid to both the company’s debtholders and shareholders. The fundamental value of the company’s stock is determined by the portion of these flows that can be paid just to the shareholders.
A minority of sell side analysts use free cash flow analysis to value Amazon’s stocks. Analysts at the former Credit Suisse, now part of UBS, are among this minority. The history of their past reports, as well as their recent reports, provides important insights into the degree to which Amazon’s current stock market valuation accurately reflects fundamentals.
On February 27, 2025, Amazon’s stock price closed at just under $210. The analyst team at UBS following Amazon set a target price of $230 for the stock. In October 2019, the team with the same lead analyst, Stephen Ju, established 2025 as the terminal year of their free cash flow analysis. In doing so, they divided their valuation number for Amazon’s stock into two components, one for the five-year period 2020 through 2024, and the other for 2025 and thereafter.
A point very important for readers to understand is that for Amazon’s stock, the analyst team assigned about 80% of the stock’s value to the period beginning in 2025. As a result, it is long-term issues that mostly drive the fundamental value of Amazon’s stock, not the short-term day-to-day fluctuations upon which investors mostly focus. The significance of the long-term provides the reason why discussions about capex are critical, as these expenditures significantly impact long-term free cash flows.
Market psychology determines the degree to which the stock market is rational. Psychology impacts analysts’ estimates of free cash flows and it impacts investors’ reactions to market events. In a rational world, if analysts’ forecasts of future free cash flows turn out be reasonably accurate, then there is reason to judge that their valuation estimates would be relatively unbiased.
Two Questions About Forecast Accuracy
Consider two questions. In October 2019, how accurate was the UBS analyst team in forecasting Amazon’s free cash flows for the period 2020 through 2024? How accurate was the team in forecasting what Amazon’s market capitalization would be at the beginning of 2025?
Based on my analysis of the UBS analyst report and Amazon’s financial statements, it appears that the UBS team significantly overestimated Amazon’s free cash flows for the period 2020 through 2024. The ratio of the average annual free cash flow forecast to its actual value was four, an optimistic bias of 300%.
The analyst team’s calculations from 2019 provide an estimate of what the value of Amazon’s stock would be at the beginning of 2025. The ratio of the estimated value to the actual value is 61%, which means that the current market value of Amazon’s stock is 63% higher than what the analyst calculations from 2019 implied.
Juxtapose the answers to the two questions. The UBS team severely overestimated by 300% Amazon’s free cash flows during the period 2020 through 2024, and yet Amazon’s stock price is 63% above UBS’s valuation estimate. In a rational market, this would be very surprising; but the evidence suggests that the market is far from rational.
Forecast Bias Of Capex
An important reason why the analyst team overestimated Amazon’s free cash flows for the period beginning in 2020 is that they underestimated Amazon’s capex. This, they did to the point of assuming that Amazon’s property, plant, and equipment would decline from one year to the next, eventually approaching zero.
The assumption of declining PP&E is unrealistic for a company like Amazon, and has no precedent in Amazon’s history. It stands completely opposite to Amazon’s stated investment policy at the time, and certainly to Amazon’s massive planned investment described above.
Why the analyst team would make such an assumption is a matter of speculation. One thing to keep in mind is that for a given level of cash flow from operations, lower capex implies higher free cash flows. Therefore, lower capex, all else being the same, leads to a higher valuation.
If the analyst team was looking for a way to construct the numbers to produce a higher valuation, this was a way to do it. In this regard, it is worth mentioning that the balance sheet the analyst team presents in their 2019 report omits values for the line item PP&E. Indeed, it is the only line item in the balance sheet with blank entries. Therefore, investors interested in the analyst team’s forecast for PP&E would have to compute the numbers themselves, which is what I did.
Sentiment Surge Beginning In 2017
In 2017, the prices of technology stocks began to increase dramatically, reflecting a discernable change in investor excitement about technology. That year Greg Ip, now the chief economics commentator for The Wall Street Journal, created a video entitled “The Economy Needs More Amazons.” The website description of the video states the following: “The U.S. has observed a long period of low stock-market volatility and economic stagnation. The Wall Street Journal’s Greg Ip believes the economy and markets could benefit from more risk-taking companies – creative disrupters like Amazon.com.”
Amazon is a good company. For psychological reasons, investors exhibit a behavior pattern known as representativeness bias by assuming that good stocks are stocks of good companies. However, irrational exuberance can leads stocks of good companies to be bad stocks.
Over the last five years, Amazon has been a good stock, returning 17% per year on average. That performance has not been generated by Amazon’s free cash flows, the basis of its fundamental value. Instead, it is the product of investor sentiment. Remember that the analyst team severely underestimated the rise in price of Amazon’s stock.
Conclusion
Investing in stocks like Amazon involves bets on future sentiment as well as fundamentals. In a world of very high expectations for AI, and large capital expenditures in developing this technology, investors would do well to understand the extent to which they are relying on sustained and growing optimism to generate attractive returns.