Sure, he understood it. Did he respect it as the prime directive? It seems not. But, plenty of companies would take the same approach and write down the losses to the cost of customer acquisition--pure marketing--with the idea being to recoup later.
That drive, BTW, is a side effect of high-pressure SV culture. Rather than build more methodically with an emphasis on creating rabidly loyal fans who are willing to pay a higher price for service, customer experience, etc, the goal was to grow revenue and customer base as quickly as possible by any means. In this case, it meant deep discounting.
So, instead of a simple misunderstanding of margin, the problem here seems to be more that this pressure caused him to embark on a strategy ill-suited to his product. Once he'd trained his customers to expect discounts so deep that he couldn't possibly profit, there was no turning back. It seems, instead, that the Zappos model would have been more suited to his offering.
But the relentless pressure for growth combined with the belief that he had access to more capital seems most responsible for his approach. I think it's possible that many rational people would have been lulled into making the same mistake, even with a clear understanding of margin. To say that he didn't understand that you have to sell a product for more than it costs to profit is nearly insulting.