A 27% ‘Instant Dividend’ From Amazon

Amazon.com (Nasdaq: AMZN) is changing the world, again. The first time this happened, Amazon was changing the retail landscape and demonstrating that success didn’t require brick-and-mortar stores. In the late 1990s, Amazon gained more than 4,500% in less than three years, before peaking at $356 (unadjusted for splits) in December 1999. Two years later, the stock was down 95%, but it was successfully selling books and adding other products.#-ad_banner-#

Since then, the world’s largest bookseller has also become the world’s largest cloud service provider. Analysts estimate that Amazon is running about 450,000 servers and enjoying revenue of at least $1 billion a year by hosting web services for third parties. The cloud world can change quickly, but Amazon’s closest competitor, according to information technology research firm Gartner, is Rackspace (NYSE: RAX), which is less than 20% the size of Amazon.

Cloud services are only a small part of Amazon’s $54.3 billion in revenue, and revenue could be the key to Amazon’s value. The company is profitable, but the price-to-earnings (P/E) ratio looks high. Based on the past 12 months, Amazon is trading at a P/E ratio of more than 315 while the industry average is 16.

The stock is priced at about 110 times next year’s earnings, based on the median earnings estimate. But the three dozen analysts following Amazon have very different opinions. The median forecast is $2.38 a share for next year with a low estimate of 92 cents and the highest estimate at $4.47. At the high end, Amazon is priced at less than 60 times earnings with earnings growth of 480%. Even at the lowest estimate, earnings are growing at 20% a year, although that puts the P/E ratio at 282. However, Amazon has a price-to-sales (P/S) ratio of only 2, near the average, and the stock could be undervalued by this measure.

Analysts’ estimates include some amount of guesswork on how successful Amazon will be in the tablet PC market. Reviews of Amazon’s most recently announced Kindle have generally been favorable and its low price point could make this product into another large cash stream for the company.

Questions about the future and the current high valuation of Amazon are almost certainly causing some investors to question whether the stock is worth the price. Their hesitation can be seen in the chart.

Amazon missed the rally that the broad market posted at the beginning of the year, but it has been a market leader since stocks bottomed in June. I think the stock could reach $320 based on the pattern formed before its recent breakout. But, even with a low P/S ratio, that P/E ratio is a little high and I’d be more comfortable buying Amazon at $220. By selling puts, we might get a chance to do that. And if Amazon continues higher, the premium from the put should offer a similar rate of return.

If there is a sell-off, Amazon has strong support near $220, the lows it started this most recent up move from. Selling January 2013 $220 puts will offer income of about $7.10. If Amazon falls below $220 before mid-January, we will buy it for $220 and have a cost basis of $212.90 after subtracting the premium received. If Amazon is still above $220 when the option expires, the premium represents a profit of 2.7% on an unmargined position based on the current stock price. Using full margin, the return would be more than 27%, which is a greater rate of return than the stock could offer if it rises to the $320 price target.

Action to Take–> Sell to open Amazon Jan 2013 Put between $6 and $7.50 (the trade’s reward is diminished outside those prices).

This put option offers the chance to profit from Amazon in the long-term whether it moves up or down. If Amazon falls, the put may allow us to buy the stock at a lower price. If Amazon rises, the options premium is income.

This article originally appeared on TradingAuthority.com:

A 27% ‘Instant Dividend’ From Amazon