Amazon founder Jeff Bezos starts his High Orde... Profits, like sausages… are esteemed most by those who know least about what goes into them. Alvin Toffler The punditocracy is blabbering on again about Amazon’s supposedly profitless business, see The Daily Beast and Slate, more discussion here and here.

If you are growing an ever more massive business without ever having to go back to markets for more capital…you are making money.

Profits are an opinion. Cash is a fact.

Amazon is generating a ton of cash ($4b in annual operating cash flow).

If the cash flow keeps growing and net income stays zero… at some point one has to conclude the net income is not really economically accurate or relevant.

Suppose you get a 30% return on invested capital, but you have to expense the investment. You have cash flow this year of $1m, you reinvest the entire amount, next year you have cash flow of 1.3m, you can do that indefinitely, keep growing cash flow from operations at 30% a year, with no earnings.

If you’re an owner like Jeff Bezos, you’re going to say, eff the short term share price, I’ll keep taking that deal as long as I can get it, it’s not like I’m going to need to sell stock or bonds with all this cash flow.

After a while the market catches on, your stock goes up. And you can borrow at 2.6% for 10 years and re-invest at an even higher rate and supercharge cash flow even more, while still showing no earnings1. Which is basically what Bezos has been doing.

Amazon has a cash cow business which is retail, opportunities to invest there in distribution centers, ‘Amazon Lockers’ etc. They have a dominant AWS cloud infrastructure business with strong economies of scale, network and platform effects, with opportunities to invest in more data centers, a better software platform. And they have the Kindle / electronic media distribution / forthcoming set-top box business, which probably doesn’t make money but along with Google is really the only thing out there that can challenge iTunes and iTV _ probably an interesting call option/lottery ticket.

As Warren Buffett said, all else being equal, it’s far preferable to purchase $2 of earnings that is not reportable (and taxable) than $2 that are.

But the punditocracy will be confused, and in fact I have no idea what ratios to use to value Amazon. You have to estimate ‘normalized’ free cash flow, ie make heroic assumptions on how much of reported expenses are really investments, then how much cash flow those investments will generate, and how much depreciation and non-cash charges are economically justifiable before you get to an earnings and growth picture you can then use for valuation. It’s not a ‘story’ stock, but it is a bit of a black box, and owning it requires considerable faith in Jeff Bezos.

‘Investment’ is not supposed to bring down earnings. Correctly accounted for, it’s supposed to be depreciated over its useful life. If writing software, bringing fulfillment centers online brings down earnings, it’s because the accounting is misleading.

It’s not that it’s some kind of charity for consumers, it’s that the earnings are underreported.

Or, to quote Warren Buffett again, accounting is the language of business, but it is an aid to management thinking, not a substitute for it.

1 Actually a loss in our example, if you expense the increased investment.