Why Netflix Stock Is Cheap Despite a 700 P/E Ratio

Netflix (NASDAQ: NFLX  ) shares have more than tripled over the past six months in a flurry of subscriber growth and big content wins. But not everyone is impressed.

The stock is heavily shorted. On Wall Street, you'll find nearly as many "sell" recommendations on Netflix as "buy" calls. Fellow Fool Adam Levine-Weinberg is not a fan of Netflix at current prices, calling it overvalued and worrying over negative cash flows. And when I presented three positive surprises from Netflix's latest monster quarter, one skeptical reader wondered how I can see the stock doubling in the next three years and "still not be worth this P/E."

Fair enough. The P/E ratio does look scary, north of 700 times trailing earnings. Negative cash flows are never comfortable, particularly for investors trained in the Foolish school of thought where cash is king. I get that. Netflix is not a stock for the faint of heart even with a few quarters of recently proven success under its belt.

But P/E ratios are a terrible metric for valuing Netflix today. And sometimes you have to burn cash today to build a reliable cash machine for tomorrow. Netflix is currently in that heavy investment phase of the digital-media era, and it would be a horrible mistake not to step on the accelerator as hard as possible right now.

Let me show you a familiar precedent for this situation. Take a look at this chart, showing a company that was down on its luck in the early 2000s:

AAPL PE Ratio TTM Chart

AAPL P/E Ratio TTM data by YCharts

Yes, that's Apple (NASDAQ: AAPL  ) back in the iMac and iPod heyday. Earnings and cash flows were erratic and sometimes negative. Cupertino was breaking new ground in several important markets, starting with the music industry and preparing for the iPhone's launch of a smartphone revolution.

P/E ratios were often sky-high or impossible to calculate back then, given Apple's barely scraping-by financials. But that was only the surface story. Below the cracking veneer, Apple was innovating and planning ahead. Steve Jobs had seen the future, and he was busy building it. Never mind if Apple's market cap dipped for a while -- the long-term payoff was sure to be fantastic.

What happened next is the stuff of legend:

AAPL PE Ratio TTM Chart

AAPL P/E Ratio TTM data by YCharts

Apple shares skyrocketed more than 1,100% between 2005 and 2012 as Steve's vision turned the smartphone and tablet markets upside down. This was the game-changing future that Apple was spending its operating cash on a couple of years earlier.

And this is the kind of market traction that Netflix is building right now.

Digital video is still a very young industry. Netflix is leading the way into a new era in the same way that Apple created all-new markets in music and mobile computing during the last decade. Netflix is spending money now so it can reap the fruits of a peerless money-making tree in the coming years.

In short, Netflix stock today reminds me of Apple in 2005. There will always be skeptics, but the company is poised to keep crushing them. Enjoy the ride -- I sure will.

The Motley Fool has released a premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. The report includes a full year of updates to cover critical new developments, so make sure to click here and claim a copy today.


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Comments from our Foolish Readers

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  • Report this Comment On April 27, 2013, at 12:16 PM, MKArch wrote:

    Anders,

    I have been a long time NFLX bear and had an eye opener exchange with someone on S.A. explaining how the movie to the home industry works, that I'm convinced knew what he was talking about as he was too detailed to be faking IMO. I'm still not a NFLX fan but here's the case based on my shorthand explanation of how the premium tv service industry works.

    I don't remember the exact number but there are something like 5 or so incumbent premium channel content providers like HBO and Showtime. They traditionally bid against each other for rights to movies where the total amount of this product runs about $7B or so (going by memory). In this system if you pay up for the best content you make it up by charging higher fees to the end user subs through the Cable providers who roughly split the fee with the premium content services. In this system the cable companies don't care who gets what content because they can sell any of the premium services and get their cut.

    Along comes Netflix who disrupts this cozy arrangement by cutting out the cable provider middle man which enables them to sell this content directly to end users at half the price of the incumbent premium services/ cable companies. It's a little trickier than this though because the movie studios that make and sell this content; sell it to the highest bidder for a fixed period of time ranging from a year to a few years. So you need scale to compete for this content because of winner take all (for a few years) highest bidder nature of the movies to the home side of the content business.

    So Netflix looks to have gotten to the scale that they can compete with the largest of the incumbent premium services HBO for movie content and if they keep adding subs they will be in a position where they can wrap up most of movie content people want to watch sell it at half of what the incumbents/ cable charge for the left over content and most likely choke these services out. WhoooHooo! if your a NFLX shareholder right?

    Well not so fast. While Netflix now has the scale to out compete with the incumbent premium channel services they are a pimple on the butt's of the cable companies and if they choke HBO and Showtime out they also choke Comcast out. When this happens look for cable to step in by either buying out the incumbents services or just skipping them altogether and bidding directly for movie content with the intent of crushing Netflix.

    Don't believe me? Ask yourself why Hasting was trying to suggest Netflix is just another premium service that the cable companies will be selling when at $8.00/ month the argument is ridiculous? I haven't followed his creepy shareholder letters in a while but he was consistently telling shareholders that Netflix primary competition was not Amazon or Hulu it was the cable companies. Why do you think Comcast is pushing X-Finity?

    Netflix shareholders would be wise to watch out for that 800# gorilla they're messing with. It's just a matter of time before the gorilla's had enough and fights back.

  • Report this Comment On April 27, 2013, at 12:34 PM, WebHound wrote:

    According to your charts displayed in your article NFLX looks more like AAPL in 2003-2004 with its PE ratio skyrocketing. There is one huge difference between AAPL and NFLX at this present moment -- taking a small pole amongst family and friends who subscribe to NFLX you get mixed reviews on the NFLX product such as statements of "the movies are old" or "we like the special series and sitcoms available on Netflix." Unlike the perception of Apple products which were known to be superior to its competitors and everyone wanted an Apple product and the only issue was the higher cost compared to its competition. The demand more than over came the cost which propelled Apple to its present status. Netflix has hard competition of its own right out of the starting gate in its early development. Netflix does have the most content available for streaming but does not provide a product that allows Netflix to increase its subscriber fees without incurring drastic subscriber loss to competitors. Unless Amazon and other streaming content providers drop out of the race, Netflix will have a hard road to travel with the high cost of providing the content - I do believe Netflix will survive but it is hard to expect the SUPER STAR performance that the PE 700 ratio indicates -- it would take a huge jump in subscriber membership to justify this along with Netflix's ability to increase subscriber fees -- which seems to be a hard sell for me.

  • Report this Comment On April 27, 2013, at 1:10 PM, Cbrenner20 wrote:

    I'm not a fan of NFLX at this price at all. No competitive moat, far too many free alternatives, other pay competitors have better/more recent content. As the streaming to your TV model matures and becomes more familiar to folks both through TV/streambox integration with internet connectivity and the often times laymans techno limited knowledge of "i can do more than stream NFLX". I don't see NFLX maintaining a growth assigned PE. Seems to me a 20 to 30 PE at best will be bestowed on them by Mr. Market... Until then its purely a momentum trade on both sides up and down. The next down coming sooner. My two

  • Report this Comment On April 27, 2013, at 4:12 PM, lanceim59 wrote:

    Only innovative companies with breakthrough products or services can succeed with ultra high PEs. Netflix is just not at the level of Apple(with tablets) and Google(with search engines), or even the future Westport Innovations Inc.(with nat. gas engines).

    Anders, you should ride the Netflix hype-train for a long, long time. It's just typical Motley Fool investing.

    I'm shorting this stock at current levels.

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