Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?
One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide if Netflix (Nasdaq: NFLX ) fits the bill.
The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.
Some of the most basic yet important things to look for in a stock are:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
- Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
- Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
- Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Netflix.
|Factor||What We Want to See||Actual||Pass or Fail?|
|Growth||5-Year Annual Revenue Growth > 15%||25.8%||pass|
|1-Year Revenue Growth > 12%||25.1%||pass|
|Margins||Gross Margin > 35%||37.7%||pass|
|Net Margin > 15%||7.3%||fail|
|Balance Sheet||Debt to Equity < 50%||134.3%||fail|
|Current Ratio > 1.3||1.71||pass|
|Opportunities||Return on Equity > 15%||54.6%||pass|
|Valuation||Normalized P/E < 20||58.80||fail|
|Dividends||Current Yield > 2%||0%||fail|
|5-Year Dividend Growth > 10%||0%||fail|
|Total Score||5 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Netflix weighs in with a mid-range score of 5. Yet for a relatively young company, Netflix has been doing a lot of smart things lately.
Having helped send Blockbuster into bankruptcy, the company that pioneered mail-delivered videos hasn't rested on its laurels. Increasingly, subscribers are taking advantage of Netflix's arrangements with game console makers like Sony (NYSE: SNE ) , Microsoft (Nasdaq: MSFT ) to stream video directly over the Internet to the Playstation, Xbox, and Wii. Although Amazon.com (Nasdaq: AMZN ) and Apple (Nasdaq: AAPL ) offer similar streaming, they do so on a piecemeal pricing basis rather than Netflix's monthly subscription.
That hasn't stopped competitors from trying other models. Coinstar (Nasdaq: CSTR ) offers video rentals at its Redbox kiosks, and NCR (NYSE: NCR ) isn't letting the Blockbuster name die as it ramps up its competing Blockbuster Express kiosks. But so far, Netflix has shown no signs of slowing down on the path to domination in the industry.
So what's not to love about Netflix? The biggest concern is valuation, although high-growth companies often sport high multiples throughout their early years. And although Netflix doesn't pay a dividend now, it has the free cash flow to support one once it stops reinvesting as much money into its business and pays down some of its debt. For now, though, shareholders are quite content with the stock's huge capital appreciation in recent years.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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