This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the worst ...
Shares of DVD-by-mail specialist Netflix (Nasdaq: NFLX) are taking a detour from today's rise in the markets and heading south for the spring in response to a downgrade from -- of all people -- CAPS laughingstock Soleil Securities.

(Just kidding, Soleil. We're not really laughing. On the contrary, we feel your pain at the knowledge that you rank in the bottom 40% of investors, and we weep at your record of 43% accuracy.)

According to Soleil, Netflix shares are fully valued -- overvalued, even. The analyst argues that the share price already incorporates both the company's victories over Blockbuster (NYSE: BBI) and Wal-Mart (NYSE: WMT) in the DVD-by-mail game, and the chance of an "earnings beat" this quarter. Soleil argues further that Netflix's cost of doing business has increased, and will continue to increase, as the firm feels compelled to purchase both standard DVDs and their new-and-improved Blu-ray analogs, so as to be able to serve both everyday customers and early adopters of the new technology.

A record mired in misery
But why should we listen to Soleil in the first place? After all, reviewing the analyst's record can be as painful as staring too long into the sun:

Even more painful, perhaps, when you observe that the sample of stock picks I've pulled above lies squarely within Netflix's domain. When it comes to e-commerce, movies, and Internet downloads, Soleil's record seems middling at best.

One stock you don't see on that list of active Soleil recommendations, however, is Netflix -- because the stock is no longer, well, actively recommended. But how did it perform for Soleil when it was recommended? Actually, it edged out the market's performance ...

... by 113 points
Yes, 113 points. Investors who listened to Soleil back in June 2007, and bought the stock on Soleil's say-so, have more than doubled their money. And in this Fool's view, investors who listen to Soleil today will have a better chance of holding on to those gains.

Why? As Soleil's downgrade implies, it all comes down to valuation. Listen, folks -- Netflix is a great company. I'm a customer myself, and I can't argue otherwise. It's so good, in fact, that both Brothers Gardner have simultaneously recommended the stock to members of Motley Fool Stock Advisor -- an unheard-of event. But despite all that, it's just too danged expensive.

Even if Netflix achieves the 21%-per-year growth rate that most analysts expect of it, this cannot justify a P/E ratio of 40. Even less justifiable is the stock's absurd price-to-free cash flow ratio. As I calculate it, once you deduct the cost of capital expenditures and DVD acquisitions from Netflix's operating cash flow, Netflix is left with just $24.1 million in trailing free cash flow. Divide that into the firm's $2.5 billion market cap, and you come to the startling realization that this company is selling for a triple-digit P/FCF ratio -- the stock sells for 104 times its annual "real" free cash flow.

Foolish takeaway
So is Soleil a lousy stock analyst? Sure. But the simple fact is: When it comes to Netflix, you don't have to be very smart to see that this stock is priced to the moon, and bound to fall soon.