Netflix (NFLX 0.22%) is one of the tech giants that has carried the stock market since the pandemic started, but it might not be the best option for growth investors. You might be able to get just as much growth with substantially less risk by owning the entire Nasdaq 100 index.
Netflix is delivering strong growth
Netflix has enjoyed a lot of positive coverage in the news lately. Squid Game is one of the most watched shows of all time, with more than 140 million viewers in its first month. That's a great way to attract and retain subscribers to keep those monthly cash flows coming.
Netflix extended that momentum by posting great earnings results in October, exceeding Wall Street's estimates for subscriber growth by 15% and earnings per share (EPS) by 25%. The company's sales rose 16% over the prior year, and it expects to achieve similar results in the fourth quarter.
Netflix is creating the quality content that's necessary to compete in the streaming video market with the likes of Apple, Alphabet, Amazon, Walt Disney, Comcast's NBC, and AT&T's HBO. It's delivering a respectable growth rate for a company of that scale, which helps drive strong returns for shareholders.
Individual stocks vs. index investing
This is one of the great disputes among investors. Indexers have plenty of ammunition to support their approach. Indexes have produced decent long-term returns throughout the entire history of the stock market. Indexing isn't time-consuming, and you don't have to pay an expensive analysis and management team to implement it. Investors can use exchange-traded funds (ETFs) or mutual funds that are designed to track major indexes. The Invesco QQQ Trust (QQQ 1.43%) is an extremely popular market-cap-weighted ETF that mimics the performance of owning every stock in the Nasdaq 100.
Diversified portfolios drastically reduce company-specific risk, so no single stock can destroy your returns by experiencing unexpected struggles. It's a simple, efficient, low-risk approach that's produced sufficiently good results for most investors.
Index funds aren't perfect, though. Diversification might reduce risk, but it also dilutes your gains. If you buy a whole index, then you're buying the losers as well as the winners. Your returns are also completely at the mercy of market-wide dynamics, so you can't expect to avoid losses in a bear market.
Ultimately, though, you can't expect to beat the market if you own the market. If you want to maximize your long-term potential, indexes aren't necessarily the way to do that.
Netflix vs. the Nasdaq
To compare these two options, we really need to understand the growth and risk profile of each.
Oddly enough, the Nasdaq is relatively similar to Netflix as far as these comparisons go. FAANG stocks and other tech giants have outpaced the market as a whole over the past 18 months. As a result, a small number of stocks now make up more of the index than ever before. The 10 largest holdings are nearly 57% of the total portfolio for the Invesco QQQ Trust -- Netflix is about 2% of the allocation on its own.
Tech stocks make up nearly two-thirds of the index. As a result, the Nasdaq 100 has relatively high sales growth rates. Amazon, Apple, Alphabet, Microsoft, Meta Platforms, Nvidia, and Tesla all have faster growth profiles than Netflix, and they are driving growth for the Nasdaq. Without the advantage of higher growth potential, it's hard to justify lower diversification.
It's riskier to own Netflix than a Nasdaq index fund. Netflix is in a highly competitive market, and it constantly has to demonstrate value to consumers who are free to unsubscribe at any time. Content creation is therefore a major expense, and it only has a 45% gross margin year to date. That's low relative to peers, and it probably won't get better moving forward -- Netflix competes on price and quality, which squeezes margins. Despite this, the stock's forward P/E ratio is above 50. That indicates a high P/E-to-growth ratio around three, based on a 15%-18% forecast growth rate. That means that the stock is fairly expensive, even after controlling for expected growth. The weighted average P/E ratio for the Nasdaq 100 is only around 35, despite its skew toward large-cap tech stocks. Netflix has more room to drop than the index.
We are seeing these dynamics play out in real time. Netflix has far outpaced the Invesco QQQ Trust since launching, but that advantage shrinks over more recent periods. Their returns have been nearly identical over the past three years.
A case can certainly be made that individual stocks have better long-term prospects than index funds. That seems unlikely in the case of Netflix and the Nasdaq, based on growth and risk. Some investors with high conviction about Netflix might just need another growth stock to plug into their portfolio. For most people, though, an ETF is the better bet.