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It has been one of the most confounding rallies in the post-9/11 period -- and it is about to collapse.

Web retailer

Amazon

(AMZN) - Get Amazon.com, Inc. Report

is up sevenfold in two years, enough to send the bears who have long baited the company into permanent hibernation. But it's high time they sank their teeth back in, because all the ill-founded assumptions that caused the stock to soar during the Blodget-era bubble are back. Yes, once again, Amazon is trading as if it were already fabulously profitable (it isn't) and as if it lacks serious competitors (it doesn't).

To be sure, Amazon and its CEO, Jeff Bezos, deserve some kudos for removing the company from what looked like a fast track to bankruptcy. Skeptics' dire predictions failed to materialize after the company slashed costs and found new markets and products to sell over the Internet.

Seattle-based Amazon has yet to report any net income, but other, gentler measures of profitability have crept into positive territory. In the second quarter, the company made 10 cents a share, using its "pro forma" income yardstick. In a sense, that was an achievement, since so many people thought it would never get that far. But pro forma profits are no big deal. For anyone not around in the boom, pro forma was the weasel adjective applied to earnings that left out all sorts of expenses that desperate companies wanted investors to ignore. Amazon is supposedly no longer a desperate company, yet it mysteriously clings to the misleading measure in its earnings releases. Not a good sign.

On Friday, Amazon rose 49 cents to $45.68. The scorching rally since late 2001 has left the stock ridiculously overvalued. Analysts expect Amazon to make 57 cents per share of pro forma earnings this year, which means the stock is trading at a price-to-earnings multiple of 79 times. There is no persuasive reason for Amazon to be trading above 35 times earnings. But what earnings do we use? If applied to the 35 multiple to 57 cents of bogus pro forma earnings, we'd get to a stock price of $20 -- more than 50% below current levels. But the stock should actually be a lot lower, even under super-bullish scenarios.

Step by Step

Why use a price-to-earnings ratio as high as 35 times for our target? That's the multiple

Wal-Mart

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(WMT) - Get Walmart Inc. Report

trades at, using forecast earnings for its 2004 fiscal year ending in January. Amazon's supporters like to argue that it deserves a higher multiple than even the kingpin of traditional retailers because of its greater success in holding down expenses as revenues grow. That is true to some extent, but the advantage this may give Amazon is not as a big as they'd like to think. Moreover, profit machine Wal-Mart is saddled with a huge expense that Amazon doesn't face -- corporate tax. (Amazon doesn't have to pay taxes right now because of past losses.) That difference must be factored into any comparisons.

The next step is to assess Amazon's revenue growth. Again being generous, we can take the consensus revenue estimates provided by Wall Street analysts to Thomson Financial. Those have revenue coming in at $5.07 billion this year, and then rising 19% in 2004 to $6.04 billion.

Amazon has never shown any real ability to boost revenue faster than costs of goods sold, so we can keep that cost line at around 75% of sales, producing gross profit of $1.51 billion in 2004.

Again going out of our way to plead Amazon's case, let's assume the company cuts its cash operating expenses as a percentage of sales to 17.5% in 2004, from the current trailing 12-month number of 18.6%. If we subtract 17.5% of sales, or $1.06 billion, from our gross profit, we get cash operating profit of $453 million. If we then take out stock option expense of an estimated $90 million and net interest expense of, say, $100 million, we get pretax profits of 61 cents per share in 2004. At 35 times earnings, Amazon would be trading at just over $21.

But we can't use Wal-Mart's multiple unless we do Amazon's income statement in the same way as Wal-Mart, which means subtracting tax, at a 35% rate. This would put Amazon's projected 2004 earnings at 39 cents a share, and the stock at $13.77 on a 35 times multiple. To get to $20, we need to adopt wildly bullish projections, like having Amazon increase revenue by 25% in 2004 and reducing its cash operating expenses down to 16% of sales. That would get pretax per-share earnings as high as 87 cents for 2004. Tax-effecting those takes them down to 57 cents. At 35 times, the stock would be almost exactly at $20.

The China Shop

Clearly, bulls will argue that 35 times is just too low, especially since analysts are expecting a 50% increase in earnings in 2004. But remember that we are using estimates from Wall Street analysts, who are typically Panglossian in nature. And even if the 2004 growth does materialize, it is dangerous to ascribe a very high P/E multiple for growth that may be one-off in nature. Wal-Mart earned its multiple through long-term domination of its particular sector. And outside of books and other media, Amazon doesn't dominate. Indeed, it must face-off against Wal-Mart, as well as other Web-exploiting established retailers, to sell a range of products on the Internet.

The bears do have an advantage in one area, however, and that is Amazon's recent strong cash generation and balance sheet management. If we use cash flow and not earnings to calculate a stock price, we get to higher levels. For example, Wal-Mart trades at 35 times its fiscal 2003 pretax free cash flow -- cash flows from operations minus capital expenditures with cash taxes added back. Amazon could make $330 million in pretax free cash flow in 2004, which is our $453 million in cash operating earnings minus $100 million of interest and $20 million of capex. Multiplied by 35 gets us an $11.7 billion market capitalization, or around $27 per share.

Free cash generation under our fatter-margin, higher-growth scenario could be $450 million in 2004, which translates into a $36 stock price with a 35 times multiple. That is about the best the bulls can hope for -- and it is still 21% below current levels.

Look out below, as we used to say during the bubble.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

peter.eavis@thestreet.com.