Has Netflix Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, and then decide whether Netflix (Nasdaq: NFLX  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • 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 mean nothing if a company can't produce profits from them. Strong margins ensure that the company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. 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

Five-year annual revenue growth > 15%

24.8%

Pass

 

One-year revenue growth > 12%

30.1%

Pass

Margins

Gross margin > 35%

31.2%

Fail

 

Net margin > 15%

2.9%

Fail

Balance sheet

Debt to equity < 50%

58.1%

Fail

 

Current ratio > 1.3

1.43

Pass

Opportunities

Return on equity > 15%

19.4%

Pass

Valuation

Normalized P/E < 20

36.94

Fail

Dividends

Current yield > 2%

0%

Fail

 

Five-year dividend growth > 10%

0%

Fail

       
 

Total Score

 

4 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Netflix last year, the company has dropped a point after holding steady between 2010 and 2011. A decline in gross margins cost the streaming-entertainment company the point, but far worse is the 40% drop the stock has suffered over the past year.

A year ago, it looked like Netflix had made a mistake from which it would never recover. After its Qwikster debacle, Netflix seemed vulnerable to Coinstar's (Nasdaq: CSTR  ) Redbox on the DVD side of the business and to Amazon.com (Nasdaq: AMZN  ) in the fight for streaming content. As DVD subscriptions have fallen, Netflix is increasingly committed to its stated strategy of focusing primarily on streaming.

One area where Netflix is trying to improve is in streaming quality. Whereas it has traditionally outsourced to Akamai Technologies (Nasdaq: AKAM  ) and Level 3 Communications (NYSE: LVLT  ) , Netflix will instead try to create its own network for digital delivery, potentially cutting out the weak link of third-party providers. That's a costly investment, but given that some customers have held onto DVD service or left the company entirely because of poor streaming quality, the move could be well worth the effort.

The real key for Netflix, though, will be content. With content providers understanding the leverage they have, they're playing Netflix off its rivals in an attempt to get the best possible price. Yet many argue that content providers need streaming just as much as streamers need content.

For Netflix to improve, it needs to establish its value proposition at the same time it continues its international growth. Big capital investments could hit earnings for a while, but in the long run, they could pay off for Netflix.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfection than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate the best investments from the rest.

A single article can't give you all the information you need to fully evaluate Netflix. That's why I'd encourage you to dig deeper by checking out our brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons why you should buy or sell Netflix. We're also offering a full year of updates as key news hits, so be sure to click here and claim a copy today.

Click here to add Netflix to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Dan Caplinger has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services recommend Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 17, 2012, at 11:10 AM, pauldeba wrote:

    Return on equity is not greater than 15%, not on book equity, not on market cap. They will make less than $1 per share next year on $12 book per hsare and $67 market per share, how is that >15%

    so, 3 out of 10 is not perfect, not even challenging Ted Williams.

  • Report this Comment On October 17, 2012, at 5:42 PM, findlex wrote:

    What about the importance of brand equity and leadership in assessing a stock? Netflix is no Apple but I would hazard a guess Apple's score on this table in 2002 wouldn't have looked too flash. Netflix is one of the most recognized brands in content streaming in North America (if not the most) and has solid leadership in for the long haul and willing to take some risks. As a marketing guy I'd think brand equity (or potential brand equity) would be a critical component in assessing perfection.

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