Yesterday, Netflix (NFLX) beat both analyst’s earnings and revenue estimates. After the market closed, it was hammered down 12%. Are investors and speculators deciding that the “music is about to stop and they want a chair”. After all, the story of Jack and the Bean Stock is just that – a story. I haven’t yet seen a bean stock grow to the sky.
With every bull market there are always sweetheart stocks that investors and speculators love. They climb to the clouds and sell at stratospheric prices and price earnings (PE). NFLX is selling at a trailing PE of 237! A much generalized median PE over time is 15. NFLX’s high PE indicates the “market” expects NFLX to have unbelievable growth in their earnings for some time.
These types of high flying companies are always around in a robust bull market. A study of history shows that very few will sustain the expected growth over the long term. Most with either “blow up” or drop to a much more reasonable level of valuation, but speculators ALWAYS get caught up in the hubris of rising markets!
As an investor, it is critical to understand that there is a huge difference between a great company and a great stock. Don’t confuse the two. NFLX is a phenomenal company. They have built an outstanding platform and established a great competitive advantage. I watch NFLX much more of the time than “junky” cable channels, but is it a “magic bean”?
Here is what I see:
- NFLX is a great company. A lot of people are moving to that mode of entertainment. Cable and dish are being dropped like a sack of hot potatoes. Most younger people don’t ever get cable.
- At NFLX’s current price of $359, they have a long way to go to reach their “expected” valuation reflected in their PE. Eventually all companies fall back “into the pack”. In finance, this is called “regressing to the mean”. Considering that the long-term average PE of stocks is about 15, this means with the current price of $359 (assuming, unrealistically, that it stays the same) NFLX will have to earn $23.93/year (359/15). Its annual earnings in 2017 were 1.25. Suppose it has to reach that $23.93 in 10 years. This means earnings have to grow, consistently by 34% each year for ten years straight! To that I would say, it is highly unlikely. It would be similar to sprinting a marathon!
- What an investor should do is a direct function of their cost basis (what they paid for the stock). If they bought it at $12/share, they’re not in a risky situation. Let’s say they’re “playing with the houses money”. But if they bought it at $350/share, they are in a wholly different situation. It would be similar to falling off Mount Everest, if things don’t pan out!
- While I believe NFLX is firmly established in the market place and will be hard to challenge, the cable and dish providers are not just going to sit by idly and let NFLX eat their lunch. Those competitors are well capitalized, large companies who WILL fight back. Has NFLX awakened a sleeping giant(s)? This is referred to as the secondary effect. Every action begets a reaction, so it isn't so simple to just look at the first effect.
- Right now they don’t have commercials, but what will the future hold? Sooner or later growth will slow and they will be looking for ways to eke out more profits. Then….. the commercials will be back. NFLX will be dropped for the next new thing and the cycle continues.
MTV came out when I was in college. Yes…I am old as dirt as my kids would say. I would prefer to say that I am seasoned. MTV had no commercials and played music videos all day and night long. It was amazing for the time. Now, MTV is full of commercials and other junk.
If you think NFLX can grow to the sky, go for it. But, like always, make sure you are as aware of your downside risk as your perceived upside potential.
By the way, can I interest you in some magic beans? They are a steal at only $359/each!
