As of this writing, Netflix is quickly approaching $100 per share. Just 3 short months ago, Netflix was riding momentum and reached its all- time high at $304.79. What happened?
In November of 2008, you could have bought Netflix shares at a price of about $19. Over the next 2 years, it climbed to that $300 high of a few months ago. The reason for the climb was the company was breaking new ground. It was a company that found a different way to do business and there were essentially no competitors. As the company’s business model took off, the earnings grew and continued to grow. Investors jumped on board, recognizing the potential for the company. It did not disappoint.
But as share prices sky rocketed, there were warning signs. The company P/E ratio started climbing to numbers that were extremely high – upwards of around 80. Normally, we like to see a P/E ratio at 20 or lower. This meant that Netflix shares were trading 4 times higher than what we would typically like to see – based on the earnings the company was generating.
Initially, investors are willing to pay a higher P/E if the earnings keep growing. In essence, investors realize they are paying a lot more for the company, but they expect the company’s earnings will keep growing. As P/E continues to grow, there is less room for any sort of misstep by the company. The share prices are only justified by the company’s explosive growth. If there is any sign of the growth not being sustained, share prices will drop.
When Netflix announced that it was dividing the company into two parts and raising prices for its subscription, it caused the share prices to plummet. Due to the uproar from subscribers, there was a concern that the current number of subscribers was going to drop and fewer renewals would occur. This would then affect the earnings of Netflix. Investors saw the writing on the wall and started to unload those shares which have resulted in the price drop we have witnessed.
As of now, the current P/E is still high at over 28 but certainly much lower than 80. If share prices drop down below $80, then we have a much more reasonable P/E ratio for Netflix.
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