The Day Tradette

Master the Stock Market


2015: the year of Netflix (NFLX) and Taylor Swift. Not only has Netflix nearly doubled in share price in the past year, but the stock hit an all-time high yesterday and is now trading at about $615. Now, I love Netflix as a company. I think more and more people, particularly new college grads, are getting rid of traditional cable, and Netflix has an advantage over competitors with its fantastic original content*. But the fact that Netflix is trading at $615 a share may be off-putting to investors, who could automatically think it’s too expensive. Today’s post is part one in a two part series on Netflix, where I ask: is Netflix too expensive?

I’ve been giving a lot of thought to whether or not Netflix is worth in investing in, and that’s coming up in part two. But first, I think we need to talk about how exactly we measure how expensive a company is. Hint: it’s not just about the price per share. So in today’s post I’m breaking down the two factors that might give us a better sense of how to value a stock.

*Go watch Unbreakable Kimmy Schmidt if you haven’t seen it yet – it’s hilarious.

The thing about stock prices is that a dollar doesn’t always equal a dollar. In other words, you can’t value a stock based on its price alone. That’s because stocks are all about relative value – how expensive they are in terms of other stocks.

It’s kind of like buying a pair of shoes. On their face, the $200 pair of shoes are technically more expensive than the $100 pair of shoes. But when you take into account other factors – like how often you’ll wear them, what material they’re made of, how comfortable they are, how durable they’ll be – the $200 shoes may be a better value than the $100 shoes. Stocks work the same way.

To understand how “expensive” a stock is, we really need to understand two other things first: price to earnings and market capitalization.

Price to Earnings

The price to earnings ratio (P/E) is a term I’ve talked about a lot here on the blog. It’s quite literally the price per share divided by the earnings (net income) per share. In other words, it shows you how much each share is backed up by actual earnings. As you might imagine, a lower ratio is better because it means each share’s value is very closely linked to how much money the company is making.

Take for example, Apple’s (AAPL) P/E ratio. AAPL has a relatively low ratio of 16x. That means that each share is worth 16 times the share’s split of the total net income.

P/E ratios are commonly used as a valuation method to tell how expensive a company is relative to other companies. It’s a useful ratio because it gives a consistent way to measure values. As I explained above, a dollar in one company’s price isn’t necessarily the same as a dollar in another company’s price.

A P/E ratio is like taking a whole bunch of measurements in inches, feet, and yards, and converting them all to meters so you can actually compare the sizes.

A low P/E ratio tends to be the sign of a value stock, or possibly an undervalued stock. A high P/E ratio implies there is not a lot of earnings behind each share, meaning the share’s high price is propelled more by expectations than by past earnings. In general (and in a very basic form), a high P/E ratio = “expensive” and a low P/E ratio = “cheap.”

Please note that a low P/E ratio doesn’t necessarily mean you should buy the stock, just like a high P/E ratio doesn’t necessarily mean you should sell. There are all kinds of reasons a company could be highly valued, such as it has great growth prospects (and that’s something you might want to own). The P/E ratio is just one tool out of many you can use to make your investment decisions.

That said, let’s look at Netflix’s P/E ratio. Netflix has a P/E ratio of 160. That’s quite expensive (again, Apple’s is one tenth of that). But, Netflix is most definitely in the growth stage, which means a higher ratio is likely justified (just maybe not one that’s this high).

Market Capitalization

A company’s market capitalization (market cap) represents the total value of the company. It’s calculated as the number of shares outstanding times the price per share. In other words, it tells you how big the company is.

For example, if you operate a public corner grocery store with 100 shares outstanding, each worth $10 a share, your company has a market cap of $10,000. Whole Foods (WFM) on the other hand has a market cap of $15 billion. But this makes sense given how much bigger Whole Foods is than your corner store.

Netflix has a market cap of $37 billion. To better understand how that affect’s Netflix’s value, let’s look at Netflix’s market cap compared to Facebook’s (FB).

On a pure price per share basis, Netflix looks significantly more expensive than Facebook – $615 per share vs. $80 per share.

But now let’s compare the market caps. Netflix has a market cap of $37 billion, while Facebook has a market cap of $225 billion. That makes Facebook’s total value 6 times that of Netflix’s.

Whoa! It’s like it’s opposite day.

So how does this affect our understanding of how expensive Netflix is? Well, these different market caps tell you two things.

Owning a share of Netflix gives you a larger percent of the company than owning one share of Facebook does. That makes each Netflix share inherently more valuable than each Facebook share (and thus supports a higher dollar price than Facebook).

There are less shares of Netflix available for purchase than there are shares of Facebook available for purchase.

If we run a quick calculation, we can use the price per share and total market cap of each company to figure out the number of shares outstanding of each. If you run the math, you’ll see that Netflix has about 60 million shares outstanding, while Facebook has 2.8 billion shares outstanding – 46 times more!

There’s an economic concept called supply and demand. As supply goes down (there’s less available to buy) and demand goes up (people want to buy more), the price of the good goes up. It’s the same case here for Netflix. There’s a lower supply of Netflix shares than of Facebook shares, which in turn supports a higher price.

So there you have it. Two concepts that show how Netflix’s “expensive” price of $615 per share may not be as expensive as it seems.

I’ll note again that these concepts don’t prove Netflix is a buy. There are lots and lots of other factors that could still make the price overvalued – like growth prospects, customer use, cost of content, etc. But, it’s important that we’re able to talk about more than just stock price when we talk about value.

Next up, I’ll use these new tools to examine whether Netflix makes sense as an investment!

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