FORTUNE — The media’s vogue stock market story of the moment is “The Mystery of Amazon’s Share Price.” As the company’s shares keep hitting record highs, The New York Times, The Atlantic, Slate, Bloomberg, and many others point out that Amazon (AMZN) hardly ever reports a substantial profit and in the most recent quarter reported a loss. Yet the company is among the 20 most valuable in America, recently worth more than AT&T (T) or Coca-Cola (KO). What gives?
Turns out there’s an answer, though I haven’t seen it cited in any of the Amazon-conundrum articles. The answer is that Amazon has actually performed spectacularly over the past decade, but that performance isn’t clearly revealed in the financial reports the company is required to issue under accounting rules. Specifically, the most frequently noted bottom-line number in those reports, earnings per share – which at Amazon has been declining for nearly three years – is not what matters most to investors.
Research has shown for years that what investors really care about is not EPS but economic profit, and Amazon turns out to be a near-perfect example. Economic profit is a measure that includes the full cost of all the capital in a business, and today’s required financial reports don’t tell you that. Investors want to see rising economic profit that seems likely to keep rising. They look at EPS as a footnote.
And, what do you know, Amazon has been turning in consistently excellent economic profit growth since 2000, even as EPS has gone up, down, and sideways. How can these two profit measures diverge so dramatically? In Amazon’s case it’s simple. Accounting rules say that money spent on R&D and advertising must be fully deducted from profit in the year spent. But everyone in business knows that such expenditures are really investments that will pay off down the road. So in calculating economic profit, as done by the EVA Dimensions consulting firm, R&D and advertising are regarded as capital expenditures and are amortized over five and three years respectively. There is no free lunch, though; in the economic profit framework, Amazon’s profit gets docked each year for the cost of that new capital, at Amazon’s 7.2% cost of capital.
At Amazon, that simple change makes a huge difference. CEO Jeff Bezos has sextupled both R&D and advertising over the past five years. Under accounting rules, those massive expenditures massacre reported EPS, but they’re treated much more gently in economic profit. As EVA Dimensions chief Bennett Stewart explains, Amazon is really “accelerating investments in intangible assets and proprietary capabilities and brand strength to enhance its long-run value.”
Of course such treatment could make any company’s results look better for a few years. Amazon, however, has delivered over the long run, increasing its economic profit over the past 14 years from -$1 billion to $1.6 billion. That impressive record gives investors at least some reason to suspect the increases may continue, which would help account for the booming stock.
No one knows whether Amazon is a good investment at today’s price. Stock prices are based on guesses about the unknowable future. But the “mystery” of Amazon’s surging valuation over recent years becomes a lot less mysterious when we stop trying to understand it by looking at financial statements that were developed long ago for bondholders in an industrial economy, not for stockholders in an information economy – statements that don’t tell us what matters most to investors.