If you would have owned shares of Netflix (Ticker : NFLX) when they released their Q3 earnings report, you would have made a lot of money. Netflix’ share price increased by 18% after reporting third quarter earnings, which blew away the expectations of Wall street analysts.
Netflix (NFLX) Up 18% After Positive Earnings Surprise
Source : Bloomberg
Netflix Q3 earnings was a positive earnings surprise, as analysts expected an EPS of $0.06 while they earned an EPS of $0.12. Also, international subscriber growth was much higher than anticipated and the company posted a better-than-expected future outlook. What effect had this on Netflix’ stock price? It gained more than 18% (!) in one day.
Is this 18% Price Increase Justified Or Not?
Of course this is great news for Netflix shareholders and it’s a clear sign of improvement. However, is an 18% price increase justified or not? Well, they’ve been overvalued for a while, and an 18% price increase doesn’t make it any cheaper. Let’s look at some factors why they seem to be overvalued
Extremely High P/E Ratio
The first red flag can immediately be spotted when looking at the P/E ratio of Netflix. Currently, the forward P/E ratio stands at an incredible 151.52 (the trailing P/E ratio stands even higher at 371.22, but the forward P/E is more useful). Compare this the S&P500 average forward P/E ratio and we see the huge difference.
Netflix’ High P/E Ratio
Of course it is common that tech companies have higher P/E ratios than most other sectors of the stock market, but such a high valuation looks a lot like the valuation of tech stocks during the dot-com bubble. We all know how that ended..
Netflix is burning through cash. Currently, they have a free cash flow of -$506 million and haven’t earned positive free cash flow in 2 years. This is because they’re investing heavily in producing new TV-shows, which is of course a good thing. However, the question is whether these TV-show will pay off. Competition is increasing and increasing, with HBO, Amazon Prime, Hulu Plus and YouTube competing for the entertainment time of consumers.
Netflix Negative Free Cash Flow In The Last 2 Years
Another important point is, how long will Netflix need to continue to burn through their cash in order to increase their subscribers base? Because they’re burning through cash fast, it they’re planning to take on more debt in the near future.
Netflix Expanding Debt
Netflix announced in their Q3 earnings report that they plan to take on more debt in order to execute their expansion plans. While it already has a financial leverage ratio of 3.88. This increase in debt will weigh on Netflix’ liquidity and return for shareholders.
Netflix High PEG Ratio
Netflix is a high growth company, therefore we need to take the PEG ratio into account. Because the P/E ratio can be misleading as long as the growth of a company is high enough. However, if we assume that earnings grow more than 50% next year, we still see that it isn’t enough to justify the current P/E ratio. Even a 100% growth wouldn’t be enough to justify the price. According to Yahoo Finance, Netflix is currently trading at a PEG ratio of 6.45 which indicates its overvaluation. Normally, a PEG ratio below 1.0 indicates undervaluation, so you see Netflix’ high valuation.
So Now What?
I think Netflix is a great company and I enjoy their shows. However, I wouldn’t put my own money into Netflix. I think the company is currently overvalued and eventually the stock price needs to come down to reflect a more realistic image of the company. Right now, they need to meet extremely high expectations in order to justify the current valuation.
Note : This is just my personal opinion. I do not force this upon you and you should always do your own research before you invest in any company, including Netflix 🙂