Netflix Shares Are Climbing Today - Are They Overvalued?

By Chris Stiles • Wednesday, October 19 14:35 • Permanent Link

One of today's standouts was Netflix, a entertainment company whose shares are up 11.9%, outperforming the Nasdaq by 12.3%. At $269.49, the stock is 9.19% above its average analyst target price of $246.81.

The average analyst rating for the stock is hold. NFLX may have outstripped the S&P 500 index by 12.7% today, but it has lagged behind the index by -43.5% over the last year, returning -61.5%.

Netflix, Inc. provides entertainment services. The company is included within the communication services sector, which generally includes cyclical companies whose share prices rise and fall along with macro economic cycles. One exception are telecommunications providers, which are more akin to utilities in that demand for their services remain somewhat consistent regardless of the state of the economy.

Netflix's trailing 12 month P/E ratio is 22.9, based on its trailing Eps of $11.78. The company has a forward P/E ratio of 25.2 according to its forward Eps of $10.69 -- which is an estimate of what its earnings will look like in the next quarter. As of the third quarter of 2022, the average Price to Earnings (P/E) ratio of US communication services companies is 18.65, and the S&P 500 average is 15.97. The P/E ratio consists in the stock's share price divided by its earnings per share (Eps), representing how much investors are willing to spend for each dollar of the company's earnings. Earnings are the company's revenues minus the cost of goods sold, overhead, and taxes.

Netflix's P/E ratio tells us how much investors are willing to pay for each dollar of the company's earnings. The problem with this metric is that it doesn't take into account the expected growth in earnings of the stock. Sometimes elevated P/E ratios can be justified by equally elevated growth expectations.

We can solve this inconsistency by dividing the company's trailing P/E ratio by its five year earnings growth estimate, which in this case gives us a 7.25 Price to Earnings Growth (PEG) ratio. Since the PEG ratio is greater than 1, the company's lofty valuation is not completely justified by its growth levels.

An analysis of the company's gross profit margins can help us understand its long term profitability and market position. Gross profits are the company's revenue minus the cost of goods only, and unlike earnings, don't take into account taxes and overhead. Here's an overview of Netflix's gross profit margin trends:

2021 gross margins: 41.6 %
2020 gross margins: 38.9 %
2019 gross margins: 38.3 %
2018 gross margins: 36.9 %
Average gross margin: 38.9 %
Average gross margin growth rate: 4.1 %
Coefficient of variability (lower numbers indicating more stability): 5.1 %

While not the strongest, Netflix's gross margins indicate that its underlying business is viable, and that the stock is potentially worthy for investment -- as opposed to speculative -- purposes.

Another key to assessing a company's health is to look at its free cash flow, which is calculated on the basis of its total cash flow from operating activities minus its capital expenditures. Capital expenditures are the costs of maintaining fixed assets such as land, buildings, and equipment. From Netflix's last four annual reports, we are able to obtain the following rundown of its free cash flow:

2021 free cash flow: $-131,975,000.00
2020 free cash flow: $1,929,154,000.00
2019 free cash flow: $-3,140,357,000.00
2018 free cash flow: $-2,854,425,000.00
Average free cash flow: $-1,049,400,750.00
Average free cash flow growth rate: 14.9 %
Coefficient of variability (the lower the better): 229.1 %

If it weren't negative, the free cash flow would represent the amount of money available for reinvestment in the business, or for payments to equity investors in the form of a dividend. While a negative cash flow for one or two quarters is not a sign of financial troubles for NFLX, a long term trend of negative or highly erratic cash flow levels may indicate a struggling business or a mismanaged company.

Value investors often analyze stocks through the lens of its Price to Book (P/B) Ratio (its share price divided by its book value). As of the third quarter of 2022, the mean P/B ratio of the communication services sector is 2.62, compared to the S&P 500 average of 2.95. The book value refers to the present value of the company if the company were to sell off all of its assets and pay all of its debts today - a number whose value may differ significantly depending on the accounting method. Netflix's P/B ratio indicates that the market value of the company exceeds its book value by a factor of 5.8, so it's likely that equity investors are over-valuing the company's assets.

Since it has an inflated P/E ratio, an elevated P/B ratio, an unconvincing cash flow history on an upwards trend, Netflix is likely overvalued at today's prices. The company has mixed growth indicators because of an inflated PEG ratio and consistently average gross margins that are increasing. We hope you enjoyed this basic overview of NFLX's fundamentals. Make sure to check the numbers for yourself, especially focusing on their trends over the last few years.

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The above analysis is intended for educational purposes only and was performed on the basis of publicly available data. It is not to be construed as a recommendation to buy or sell any security. Any buy, sell, or other recommendations mentioned in the article are direct quotations of consensus recommendations from the analysts covering the stock, and do not represent the opinions of Market Inference or its writers. Past performance, accounting data, and inferences about market position and corporate valuation are not reliable indicators of future price movements. Market Inference does not provide financial advice. Investors should conduct their own review and analysis of any company of interest before making an investment decision.