The dot-com era was marked by individuals investing in technology stocks trading at extremely high multiples based on speculation of future earnings potential. For all of you main street Joe’s out there – high multiples refers to the price individuals pay for stock in relation to the company’s earnings per share (EPS)or more commonly known as a Price/Earnings Ratio (PE). A PE ratio of 10 means that an investor is willing to pay $10/share for every dollar of earnings and a PE ratio of 20 means that an investor is willing to pay $20/share for every dollar of earnings. Below is a graph of historical values of for the average price earnings ratio of the S&P 500.
The historical average of the S&P index price earnings ratio is 15.49 which equates to an investor is willing to pay $15.49 a share per $1 dollar of earnings. As of today, the average S&P PE ratio resides at 18.23.
Now let’s take a look at Netflix ($NFLX), a stock that has more than doubled since January. The main catalyst for the sudden spikes in share price come from a 40% increase in membership (combination of domestic and international customers), two earnings reports where the company demonstrated the ability to be profitable again, and the announcement of partnerships with various entertainment companies. At first glimpse, this news all sounds wonderful. However, analysis of the earnings report and fundamental analysis and the company suggest this stock is extremely OVER VALUED.
Netflix closed at $103.26 a share On January 23, 2013 and reported earnings after the bell. The company was expected to report a loss of $0.13/share or roughly $7.3 million loss. Netflix actually reported a positive earnings report of $0.13/share or a profit of $7.3 million. As a result the stock closed the next day at $143.86 and increased to over $180 a share in less than two weeks time.
During the same two week time frame the company’s market cap (the total dollar value of all outstanding shares) expanded from $5.78 billion to $10.08 billion. It does not take a rocket scientist to figure out a company should not gain over $4 billion in value from only $7.3 million in profits.
This week we noticed a similar phenomenon. Yesterday, Netflix closed up 5.2% at $174.37 and reported first quarter earnings after the bell. The company announced a $0.31 per share for the first quarter; this figure was much higher than the expected value of $0.17 a share. As a result, Netflix share price increased over 25% today. First quarter profits of roughly $17.4 million caused Netflix’s market cap to soar from$9.76 billion to over $12.21 billion (intraday value).
As a result of the sudden spike in market price, Netflix’s PE ratio has taken off. Yesterday, the company was trading at 542 times earnings. The current PE ratio for this 737 which means you must pay a premium of $737 for every $1 of earnings.
I would not be surprised if this stock continues to trend upward and certainly has the momentum to continue to do so. Additionally, I believe Netflix has the ability to maintain and increase their profitability. However, the fundamentals of this stock do not present an attractive investment opportunity. The stock is trading at an unrealistic multiple and eventually the market has a way of correcting these types of mistakes. Companies such as $DIS $CMCSA and $CBS present better investments opportunities in the media industry.
Full disclosure: I do not hold a position in any stock mentioned in this article and I do not intend to change my position in the next 72 hours.