Netflix Inc. (NASDAQ:NFLX) appears unstoppable. The company has a 20-year track record of visionary strategic moves. Also, its homegrown library of programming continues to win critical and commercial success.
While the stock price of Netflix has been among the stock market’s most impressive performers, the increase creates questions about whether the increases can continue.
Considering its valuation, investors should pause before making further investments in NFLX stock.
Netflix Makes the Right Decisions
On the surface, Netflix has a strong track record of making fortuitous strategic decisions. Founded by Reed Hastings and Marc Randolph in 1997, Netflix changed the landscape of the home movie industry.
It began as a DVD mail service. Then, it evolved into a streaming service when broadband technology improved. It forced the once-dominant video store retailer Blockbuster, Inc. out of existence and relegated DVD rentals to vending machines.
The company further evolved by creating its own programming. Programs such as House of Cards, Stranger Things and Orange is the New Black garnered widespread media attention as well as Emmy awards. Netflix does not reveal viewer numbers. However, renewals and social discussions indicate many of these shows have a large audience.
With this success, investors rewarded Netflix investors handsomely. The NFLX stock price today stands at just under $180 per share, nearly double year-ago levels. Since its IPO in May 2002, NFLX stock has risen approximately 150-fold.
An increase of that magnitude will likely leave investors wondering how much upside remains in Netflix.
Financial Metrics Indicate Growth Is Ahead of Earnings
However, some financial metrics might be a signal for caution. The price-earnings ratio on Netflix of about 220. This ratio exceeds the average S&P 500 P/E ratio by over tenfold, and prices the company for perfection. The steep price you pay for a slice of Netflix is a reflection of its revenue growth, which averaged about 22.5% over the past five years … but can that growth continue?
And while the company has been profitable for several years, earnings per share has been erratic. NFLX stock EPS achieved a high of 62 cents per share in 2014. By 2016, EPS fell to 31 cents per share.
Earnings have since rebounded. Consensus earnings for 2017 stand at $1.19 per share, with high earnings growth forecasted in later years. The increase in earnings still leaves NFLX stock with a P/E over 100. The consensus EPS for 2020 at $4.92 per share would have to hold to justify its current price.
Moreover, only the revenue growth and forecasted EPS growth rates reflect a performance worthy of a P/E ratio over 200. Return on assets (ROA), the percentage of profit compared to overall resources, stood at a modest 1.57% in 2016.
Return on equity (ROE), the profit compared to company equity, fared little better at 7.61%. While positive, these are returns more often seen with an older company such as General Electric Company (NYSE:GE) than a high-growth technology company.
Bottom Line on Netflix
The strong revenue and earnings growth for Netflix stock brought long-time investors riches. However, new investors should exercise caution.
Netflix made mostly wise decisions in making the company the technology powerhouse it is today. Its programming creations and revenue growth propelled the company to a high valuation. However, a P/E ratio over 200 creates considerable downside risk if the company makes a strategic mistake.
Strategic mistakes are the very things investors should seek. Netflix, as a company, appears strongly positioned to continue performing well. If a strategic misstep or a temporary loss of confidence lower the NFLX stock price, investors should consider adding more Netflix to their portfolios.
As of this writing, Will Healy did not own a position in any of the stocks mentioned here.