What has happened at Netflix (NFLX) over the last few days is truly remarkable. In the modern business world, most CEOs view themselves as guardians of the stock price; making money is important, but only in as much as that pushes the stock price up. So for Reed Hastings, Netflix CEO to warn in their Q3 letter to investors that the stock is too high was shocking. For him to reiterate that opinion in an earnings call on Monday was even more so.
The market took note and NFLX dropped spectacularly yesterday, losing around 9%.
Hastings’ comments are unusual, but perfectly rational. Netflix has seen this particular movie twice before. First in 2003, then again in 2011 NFLX was the stock market darling. Both times the stock collapsed quickly when valuations overtook reality, and Hastings is understandably worried that the same thing is happening again. Add to that the uncertainty surrounding the move to original programming and it would seem that Hastings is just an honest man with his shareholders’ best interests at heart.
For what it’s worth, I happen to believe he is right. Before collapsing yesterday, forward P/E for NFLX was approaching 120. When forward P/E is that high, logical people have to ask themselves if the pricing is rational and justified. Bear in mind that this is forward P/E, the ratio between price and an average of analysts’ forecasts for future revenue. Some degree of anticipated earnings growth is therefore baked in. In order to justify forward P/E at those levels, a company must not just beat future earnings predictions, but absolutely hammer them, and consistently; not an easy thing to do.
So, if an experienced CEO of a company that has been there before considers that such valuations are the result of unrealistic exuberance, are there other well known names that could be looked at the same way? There are, but often, identifying them involves slaughtering a few sacred cows. Oh well, it wouldn’t be the first time I’ve upset people, and it sure won’t be the last!
Linkedin (LNKD): Forward P/E 118.91.
The whole social networking scene is, quite frankly, beginning to look a little bubbly. At first there was a lot of doubt around the possibility of making money from the phenomenal rise of such sites and many companies were undervalued. Back in July I pointed this out with regard to Facebook (FB) and sure enough the adjustment came, but now the pendulum may have swung too far the other way.
The market’s reaction to companies such as Linkedin making a profit is somewhat akin to a person’s reaction when watching a monkey dance. The sheer wonder at the fact that they can do it at all overpowers the observation that they are not doing it very well. LNKD undoubtedly has potential and, on a percentage basis, beating earnings that have averaged $0.02 per share over the last four quarters may not be too hard, but once again, a forward P/E up around 120 may be a little too rich.
Tesla Motors (TSLA) Forward P/E 120.80.
Once again, the dancing monkey thing comes into play here. There is a sense of wonder that a company can make an electric car that is fun to drive and winning accolades everywhere at all, but for that company to make money too….just wow! I agree, it is a remarkable story and the product is great, but there is a degree of fanaticism to the true believers that troubles me, as I pointed out here.
Since that article was published TSLA has underperformed the market in general by over 50%, so maybe there are signs that true belief can only take a stock so far. It’s not that I don’t believe in the value of electric cars and other alternative energy plays, it’s just that, right now, that forward P/E screams overvalued. Incidentally, it may be that CEO and founder Elon Musk is the anti-Hastings. While the NFLX CEO uses his public platform to warn investors about getting ahead of themselves, it seems that Musk takes every opportunity to talk TSLA up even further. He is, of course, right to be enthusiastic, but potential can only get you so far. Sooner or later that 120 P/E has to be justified, and the longer it takes, the more likely a severe correction becomes.
Amazon (AMZN): Forward P/E 128.39
The AMZN story is, in many ways, a little different. This is about an established company that has overcome several challenges and looks to be on the verge of overcoming several more. Of these three examples, I believe that AMZN, despite having the highest forward P/E, has the best chance of justifying these elevated multiples.
They have acquired competitors and suppliers aggressively and wisely, but it remains to be seen if the resulting company becomes somewhat unwieldy. This is not my biggest reason for reticence, however. Rather it is the fact that the purchases of rivals indicate that AMZN is playing a kind of never ending game of “Whack-a-Mole” and competitors keep popping up. As established and respected as the company is, there is a trendy element to online retail, and barriers to entry are relatively low. Customers are fickle, and I get the feeling that the next Zapos is not far away.
Amazon will most likely continue to make money, and probably increase their profits, but, again a 128 forward P/E looks overly optimistic.
It must be stressed that phenomenal growth does frequently occur in companies, and analysts frequently get things wrong. An elevated forward P/E is not always a sign of impending doom for a stock but for the cautious investor, or in the case of NFLX the cautious CEO, it should be a warning signal. After all, what goes up must come down, even if only in a relative sense, and while we’re in cliché mode, the higher they climb, the further they fall. Be careful out there!