There are plenty of stocks with extreme valuations, and many of those valuations are based on very sound reasons. For example, if a company is projected to grow its earnings by over 20% per year, trading for 30 times forward earnings isn't unreasonable.
However, some stocks have sky-high valuations that we can't figure out. Our analysts here discuss three examples and explain why their high valuations don't make a ton of sense.
I'll inspire the wrath of many followers of the Fool's premium services, but I'm starting to think video-streaming specialist Netflix (NASDAQ:NFLX) has gotten ahead of itself from a valuation standpoint. I'll be the first to admit that Netflix has shown superior growth recently, and its potential to expand around the world gives it an amazing opportunity that could dramatically bolster its future revenue. Moreover, by charging just a pittance in the U.S., Netflix has left itself room to increase its subscription rates without coming close to what you'd pay for a basic cable television subscription.
Even with Netflix's amazing opportunities, though, paying more than 100 times trailing earnings for shares is a stretch. Looking out to 2016, investors expect Netflix to earn about $5.57 per share, which would mark growth of about 30% from the company's 2014 results. Yet even with those projections, Netflix trades at more than 80 times 2016 forward earnings estimates. Admittedly, those following Netflix have been overly pessimistic about its earnings growth in the past, and faster growth rates could justify current valuations. But with so much already built into the stock price, I'm wary of putting money into Netflix right now.
One particular stock that seems to have a crazy valuation is nevertheless appealing to me: Celgene Corporation (NASDAQ:CELG), a major biotech player with a market capitalization recently near $93 billion. Like many companies with steep valuations, investors have high hopes and expectations for this company.
How overvalued is it? Well, its recent price-to-earnings (P/E) ratio was near 50, well above its five-year average of 34, while its price-to-sales ratio and price-to-cash-flow ratios were both more than 50% above their five-year averages. That's certainly not inviting.
How did Celgene's value rise so much? To start, many investors are excited about its offerings and its pipeline. It boasts the $5 billion-a-year multiple myeloma drug Revlimid, the $848 million-a-year cancer drug Abraxane, and the $680 million-a-year multiple myeloma drug Pomalyst. The company also recently launched its first autoimmune drug, Otezla, for psoriasis, and all four of those drugs are enjoying double-or triple-digit sales growth. Its pipeline is promising thanks to collaborations and -- in some cases -- equity stakes with emerging biotech companies.
Though Celgene's stock might seem too pricey to buy right now, it's actually appealingly priced. The current P/E might be high, but the company's revenue and earnings have grown briskly, respectively at 35% and 44% annually on average, over the past decade. Between 2013 and 2014, revenue grew 18%, while net income grew 38%. Given all that, its P/E based on the next four quarters of earnings is actually low -- only about 18, which isn't much more than half its five-year average. Its profit margins are fat, with gross margin recently at a whopping 95% and net marginstopping 20%, and its free cash flow tops $2 billion annually. Celgene's valuation might seem crazy, but so does its potential.
You won't find too many stocks with higher price-to-earnings multiples than Pharmacyclics (NASDAQ:PCYC). The biotech's trailing P/E ratio stands at 147, and the forward multiple is even higher at 251.
What's behind Pharmacyclics' sky-high valuation? One drug. Pharmacyclics and development partner Johnson & Johnson (NYSE:JNJ) in 2013 won FDA approval for Imbruvica as a treatment for mantle cell lymphoma, and they followed up with approval in 2014 for chronic lymphocytic leukemia. The companies just last month secured FDA approval for Imbruvica in treating another rare blood cancer, Waldenstrom's macroglobulinemia.
Imbruvica has already proven a success story, generating about $1 billion in sales last year. Some predict the drug could ultimately hit peak annual sales of $6 billion. However, Pharmacyclics receives only 50% of the profit from Imbruvica, with J&J taking the other half. Imbruvica also faces stiff competition from the likes of AbbVie (NYSE:ABBV) and Celgene.
It's a great drug. Pharmacyclics is arguably a great up-and-coming biotech. But a great stock to buy? Not if you believe share prices eventually reflect actual earnings potential.
Dan Caplinger has no position in any stocks mentioned. Keith Speights owns shares of Celgene. Selena Maranjian owns shares of Celgene, Johnson & Johnson, and Netflix. The Motley Fool recommends Celgene, Johnson & Johnson, and Netflix. The Motley Fool owns shares of Johnson & Johnson 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.