Is Netflix one of the most overvalued stocks on the S&P 500?

The Pitch

With a trailing Price to Earnings Ratio of 330.32 and a forecast Forward Price to Earnings Ratio of 477.69 is Netflix (NFLX) one of the most overvalued stocks on the S&P 500?

The Thesis

I love Netflix, I have been a subscriber for some time now, but I don't believe I'm necessarily loyal to the brand. I believe the right content and pricing from a competitor could easily lure me away, and this concerns me as an investor. The ease at which I can switch to a different provider is brilliant for me as a customer, and perhaps this liberty they have gifted us is a key reason a lot of people choose to subscribe, but could it ultimately be its downfall in such a crowded market consisting of companies such as Comcast (CMCSA), 21st Century Fox (FOXA), and Amazon (AMZN)?

An addition to the list of competitors could also be Apple. Despite it being reported recently that Apple (APPL) has postponed their live streaming plans, I can't help but feel it is inevitable that in the near future we will see it finally launched in some form.

Apple has the cash to fund such a project and the allure to attract the talent necessary to make a success of it. I don't necessarily believe Apple will get into content creation, but rather that it is more likely to be in the same style of the Apple Music offering. This may not actually be too detrimental to Netflix though as Apple often go after the premium market which is perhaps more likely to hit cable TV providers hardest. Since Apple Music's release Spotify, who I think of as the Netflix of the music streaming world, appear to have still grown its user-base. Some say that Apple waited too long to get into music streaming, and perhaps the same will be said for TV streaming if they do.

My main concern with Netflix is that I believe we are currently pricing in anticipated growth upwards of ten years ahead in an incredibly unpredictable industry. Although this is relatively normal behavior for growth stocks, I fear investors could be overreaching here which has led to the 150% gain year to date.

The Future

Were we to fast forward ten years to a hypothetical maturing market what would I be wanting to see to justify the price today?

Well let's say for instance that the current industry average PE Ratio of 34 is where we want Netflix to be at in 10 years. This means that it would have to grow earnings, currently 38 cents per diluted share, by a CAGR of 25.53% for 10 years to $3.65 just for shareholders to not lose money.

Historically, studies have shown that the S&P 500 returns 7% per year on average, so why would we settle for a zero percent return when we could just invest in an index fund? We would not. So now let's factor in some shareholder returns into the equation too and see where that leaves us.

If we're happy with a return of 7% per year, the share price would have to almost double to $244.32 in these ten years (excluding any changes to shares outstanding). With a PE Ratio of 34 this means the Company would have to have net income of $3.071 billion per year, which equates to an earnings CAGR of 34.32% over the ten years, and diluted earnings per share of $7.19.

As you can see on the chart below the Company's profit margin is on the low side. However, as it matures I would expect to see improvements in margins that could support increased EPS growth.

Source: Ycharts

If the profit margin could improve to around 15% then Netflix would need to achieve revenue of $20.47 billion in 2025 which equates to a CAGR of 12.3%. This sounds reasonably achievable, but is heavily dependent on them being a key player in streaming still, the service being relevant, and the Company being able to reduce operating expenses substantially. Were they only able to improve the profit margin to 7.5% then within this scenario we would need revenue of $40.9 billion in the tenth year - a CAGR of 20.3%.

The Subscribers

As of Q3 2015 Netflix has 50.65 million paid subscribers and is earning $1.223 billion of revenue from them quarterly. Within the Q3 Letter to Shareholders the Company forecasted revenue of $1.667 billion from 70.42 million subscribers. This leaves us with estimated annual revenue of approximately $5.7 billion.

To reach the desired revenue from the scenario above with a profit margin of 15% Netflix would need around 200 million subscribers if we allow for moderate price increases during this period. This means Netflix would have to achieve a subscriber CAGR of 14.83% over the ten years from Q3's figures. Incidentally, 200 million people would be about 2.5% of the 8.1 billion world population in 2025 as estimated by the United Nations. Whether that is a bit on the ambitious side is for investors to decide.

If the profit margin was only 7.5% then the Company would need approximately 410 million subscribers, around 5% of the world population, to support the growth.

The (not so) Final Word

I think Netflix is a great company, making fantastic content, and providing a flawless service and I can fully understand why investors may be happy to invest now even with a high PE Ratio. But I am unsure whether they can produce the shareholder returns that I would be requiring over the next ten years. I'm also doubtful that we can suitably predict that far ahead for the future of the industry which means I would rather invest elsewhere at this point. 

I feel that the growth required to achieve acceptable shareholder returns is out of reach and investors could jump ship in search of alpha elsewhere. I would not be surprised to see the stock drop to below the $100 level in the near term.

I see the fair value today as being around $63 which equates to a PE Ratio of 167. I doubt very much that the stock would drop to this level, but if it did I would be buying as much as I could get hold of. For now I'll be targeting a drop to $100, and we'll see where things go from there.

The (final) Final Word

I realise that a PE Ratio is not necessarily the best way to value a stock at this stage of its growth. Its use in this analysis is used as a reference to a future (mature) Netflix, and if it can complete the transition and still produce good shareholder returns.

The median PE Ratio by Market Capitalization for 4888 US-listed stocks.

As many of you know here at Quantr.co we provide daily stock market data directly to your speadsheet for thousands of stocks listed in the United States, and every now and then we like to use this data to give our readers a little snapshot of the market.

Today we're looking at price to earning ratios and how they vary throughout the market as a whole depending on the size of the company. For this study we analyzed 4888 stocks and found the median value for each specific market capitalisation range.

The result for median PE ratios by Market Capitalisation as of market close on Friday November 27 2015 is as follows:

Median PE Ratio (ttm) courtesy of Quantr.co

Next the result for median Forward PE ratios by Market Capitalisation in the US is below:

Median Forward PE Ratios courtesy of Quantr.co

As for the market as a whole. After analyzing all 4888 stocks we came up with a:

Median US market price to earnings ratio of 19.78 

and a 

Median US market forward PE of 16.08. 

Results - Investment strategies investigated - Part i - Relative Strength Index

As many of you will know we started an experiment last month on the use of the Relative Strength Index to buy undervalued stocks.

The theory goes that an RSI approaching 30 (or below) is oversold, and the stock may now start an uptrend, and an RSI approaching 70 (or above) is overbought, potentially causing the asset to start a downtrend.

As of October 25 2014 there were 703 stocks that are approaching an RSI of 30. For the purpose of this experiment we are going to class 'approaching an RSI of 30' as any stock below an RSI of 40 on 14 day basis.

For this investigation we looked at the what if scenario for portfolio performance if buying all stocks approaching an RSI of 30, all stocks below an RSI of 30, as well as a specially selected group of stocks approaching an RSI of 30 that satisfy a few fundamental factors. We also sneaked in a fourth group of 20 stocks that were selected at complete random to test the validity of the results more so.

The special group of stocks, shown in the image below, were picked as they satisfied certain criterion necessary to be included in this particular portfolio.

• Return on Equity > 20% 
• Debt to Equity < 80% 
• PEGY Ratio < 2 
• Relative Strength Index < 40

Well, the results are in and they are somewhat interesting. For the record, we plan to repeat this experiment a few times to account for different market conditions and to test reliability, as we all know by now that past results do not guarantee future results.

The results:

So, as you can see disappointingly the random selection ended up the victor, outperforming all selections and the market during these 20 trading days. But that's not the whole story. There seems be a case here for a reduction in the holding period for each of the groups of stocks. 9 days turned out to be the optimal holding period during this experiment.

	RSI Special	RSI < 30	RSI < 40	Random	Market
Day 9	6.07%	1.95%	3.86%	3.22%	1.19%

As you can see above, as of Day 9 every single group of stocks outperformed the market, and by a reasonable margin. The decline that follows shortly after could show that potential RSI gains are ephemeral in nature and do not necessarily end up in overbought territory (RSI >70) before they decline once again. We should note that we were especially pleased with performance of the specially selected group of stocks at Day 9. Picking a group of downbeat, but reasonably sound, stocks rather than a blanket selection of all stocks approaching an RSI of 30 seems logical and appears valid.

We'll let you know how things go the next time we test this strategy. Feel free to try the strategy yourself and let us know how you get on.

- J

Central Bank Interest Rates as of Nov 21 2015

Central Bank Rate	Country	Rate	Previous	Change Date
Australian RBA	Australia	2.000 %	2.250 %	5/05/2015
Banco Central	Chile	3.000 %	3.250 %	10-16-2014
Bank of Korea	South Korea	1.500 %	1.750 %	6/11/2015
Brazilian BACEN	Brazil	14.250 %	13.750 %	07-30-2015
British BoE	Great Britain	0.500 %	1.000 %	3/05/2009
Canadian BOC	Canada	0.500 %	0.750 %	07-15-2015
Chinese PBC	China	4.350 %	4.600 %	10-23-2015
Czech CNB	Czech Republic	0.050 %	0.250 %	11/01/2012
Danish Nationalbanken	Denmark	0.050 %	0.200 %	01-19-2015
European ECB	Europe	0.050 %	0.150 %	9/04/2014
Hungarian National Bank	Hungary	1.350 %	1.500 %	07-21-2015
Indian RBI	India	6.750 %	7.250 %	09-29-2015
Indonesian BI	Indonesia	7.500 %	7.750 %	02-17-2015
Israeli BOI	Israel	0.100 %	0.250 %	02-23-2015
Japanese BoJ	Japan	0.100 %	0.100 %	10/05/2010
Mexican Banxico	Mexico	3.000 %	3.500 %	6/06/2014
New Zealand Reserve Bank	New Zealand	2.750 %	3.000 %	9/10/2015
Norwegian Sentralbanken	Norway	0.750 %	1.000 %	09-24-2015
Polish Narodowy	Poland	1.500 %	2.000 %	3/04/2015
Russian CBR	Russia	11.000 %	11.500 %	07-31-2015
Saudi Arabian SAMA	Saudi Arabia	2.000 %	2.500 %	01-19-2009
South African SARB	South Africa	6.250 %	6.000 %	11-19-2015
Swedish Riksbank	Sweden	-0.350 %	-0.250 %	7/02/2015
Swiss SNB	Switzerland	-0.750 %	-0.500 %	01-15-2015
Turkish CBRT	Turkey	7.500 %	7.750 %	02-24-2015
United States FED	United States	0.250 %	1.000 %	12-16-2008

Investment strategies investigated - Part i - Relative Strength Index

As some of you will be aware, Quantr.co provide investors and traders with all the tools needed to download stock market data directly into Excel spreadsheets. As we cover over 7000 US listed stocks it's a fantastic place to investigate investment strategies.

The first of our strategies is the use of the relative strength index (RSI) in buying undervalued stocks. As Investopedia explain "The RSI is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. It is calculated using the following formula:

RSI = 100 - 100/(1 + RS*)

*Where RS = Average of x days' up closes / Average of x days' down closes.

Most people deem an RSI approaching 30 (or below) to be oversold, meaning that the stock may now start an uptrend, and an RSI approaching 70 (or above) to be overbought, causing the asset to start a downtrend.

Our approach

So, for this investigation we are going to look at the what if scenario for the portfolio performance if buying all stocks approaching an RSI of 30, as well as a specially selected group of stocks approaching an RSI of 30 that satisfy a few fundamental factors.

As of October 25 2014 we have 703 stocks that are approaching an RSI of 30. For the purpose of this experiment we are going to class 'approaching an RSI of 30' as any stock below an RSI of 40 on 14 day basis.

We have placed all 703 stocks in an equally-weighted portfolio together and will track them for one month, removing individual stocks from the study as they approach an RSI of 70 and thus are categorised as being overbought.  At the end of the month we will judge the portfolio against the market performance and other portfolios within the study.

The special selection

Sometimes there are fundamental reasons why a stock is trading with a low RSI. A company that is heading to bankruptcy, for example, would see very little buying when heading to $0. 

So for this reason we have screened through our data for stocks with fundamentally strong features that may greater encourage a change in momentum.

The follow criterion had to be satisfied to be included in this particular portfolio.

• Return on Equity > 20%
• Debt to Equity  < 80%
• PEGY Ratio < 2
• Relative Strength Index < 40

Out of over 7000 stocks we were left with just 15 stocks that satisfied our criterion. These stocks were:

Once again these stocks will be held for one month, or until they approach an RSI of 70 and thus are categorised as being overbought.

Finally - for the purists.

Some people prefer to class oversold as strictly below an RSI of 30. For this reason, a third portfolio has been constructed containing 148 stocks that currently trade with an RSI below 30. The same rules apply for this portfolio.

We will report back with regular updates as we investigate this trading strategy. 

- J

A Short Case For Under Armour, Inc. Ahead Of Q3 Earnings

A Short Case For Under Armour, Inc. Ahead Of Q3 Earnings

Previously posted on Seeking Alpha on Oct 22, 2015 

Is Under Armour overvalued relative to its growth prospects?

We love Under Armour. We think it is a fantastic company with some highly marketable athletes promoting high quality products at a time where there is evidence of an accelerated global adoption of the athleisure trend.

But, is the Company overvalued? We believe, that trading at a PE ttm of 107.78, the growth UA would need to produce over the next five years to produce good to great shareholder returns is not quite achievable.

Time To Fall In Line With Its Peers

Our thesis is built on the premise that we believe the time has come for UA to start to fall in line with its peers, most notably NKE, and in five years believe the market will expect the company to be trading at a Price to Earnings ratio of approximately 33.

The current consensus is for UA to grow EPS at a rate of 23.4% per year for the next five years. Should this be the case, and that the PE Ratio drops to 33 as we predict, the outlook would be as follows:

For us, under the terms of our thesis, in order for UA to be fairly priced, and achieve an average shareholder return of 5% per year over the next five years, we posit that the Company needs to be growing their EPS by approximately 29% per year. Only then would we look at going long with UA. Were they to achieve this then the outlook could look like this:

Unfortunately, we think this growth is out of reach for the Company. Sure, we see great opportunity in the Asia market, but we don't believe there is enough there to achieve 29% annual EPS growth. Additionally, with a sustainable growth rate (ROE x (1 - dividend-payout ratio)) of 15%, there would potentially be substantial financial strain on the company to grow at any rate higher than this, let alone almost twice the SGR.

The worst case scenario, the Company only being able to achieve 15% annual EPS growth over the next five years (in line with the SGR), we would envisage the outlook to look a lot like this:

Thursday's Earnings

Before the market opens on Thursday UA will announce their third quarter earnings. The Wall Street consensus is for EPS of $0.44 and revenue of $1.173 BN. These earnings may just give us an indication as to whether 29% EPS growth is an achievable feat or merely a pipe dream.