Why P/E Doesn't Mean Netflix Is Overpriced

| About: Netflix, Inc. (NFLX)

I have seen several articles explaining how a sky high P/E ratio means a stock is ready for a fall. The problem with that simple analysis is that P/E by itself doesn't mean anything. You can compare it to the other players in the sector to see if the P/E for your company is too high but even that misses another important aspect, strategy. There are several reasons why a company's P/E may be high like focusing on growth of market share instead of maximizing profits. Amazon is a classic example. In 2012 Amazon (NASDAQ:AMZN) had a P/E above 900 and yet the stock appreciated during that same time period by over 50%, not bad for a horribly overpriced stock. Amazon's business strategy is to forgo profits to build market share. The principle is simple it's one of delayed gratification. Amazon assumes once it has achieved a massive market share and growth begins to slow because they are the dominant player in the market they will use their economies of scale to generate excess profits. This is the same principle for Netflix (NASDAQ:NFLX).

Netflix has a strategy of growth similar to Amazon. This strategy forces them to make decisions that in the short term will suppress profits and create a high P/E ratio. The expansion into international markets is utilizing a lot of their resources and losing money for the moment until they reach the customer base necessary to generate a profit. They are bringing down earnings in the short-term but the reward is huge profits in the future. They are making conscious choices to not limit their growth, which in my mind is the correct choice. Management has learned a lot from the debacle that was Quickster. Announcing the spin-off of the DVD business and the increase in fees for those that stream and get DVDs in the mail caused many subscribers to drop Netflix. This mistake cost Netflix a tremendous amount of stock value falling all the way down to $55. But also represented a great opportunity for investors to create a position in Netflix, and if you had you would have tripled your money already. Analysts expect Netflix to expand their subscriber base at a 20% clip for 2013. I read an article yesterday that pegs subscriber growth at 100 million worldwide by the end of 2018. This would translate into roughly 10 billion dollars in revenue. But the bottom line is what all of that means for the stock price.

OK, so they were successful in the market expansion efforts and developed a subscriber base of 100 million, but what does that do for earnings and ultimately stock price. The current contribution margin of the domestic streaming is 16%. The domestic streaming segment currently has 25 million subscribers so doubling that number should increase the contribution margin, since you are spreading the fixed cost of content across more users. Let's assume the margin for both domestic and international markets average out to the current margin of 16%. 10 billion in revenue would equate to 1.6 billion in income after paying for marketing and content costs. Current administration costs are $470 million so let's double that number for the increased cost of managing all of those international markets to 900 million leaving us with 700 million in profit. Now take the 33% tax rate assumed for 2012 and that leaves us with about $462 million in earnings. Currently there are 56 million shares outstanding so that would be an $8.25 EPS. But the growth is maturing and now it is time to look to maximizing profits not necessarily continuing the 20% growth rate. People say Netflix cannot raise their prices but I disagree. I am a subscriber and certainly they could raise the prices 50 cents and I would not even blink. What does a 50 cent increase look like for earnings? Well first, it is pure profit for Netflix going straight to the bottom line. At 100 million subscribers with a total additional revenue of $6 per subscribers that would be $600 million more in profit bringing the EPS to $15.32 after taxes. Even at a 20 P/E that would cross the $300 share price. I personally see this company growing faster than what I have illustrated above as they expand into even more markets and the internet enabled households in China and India increases creating even more opportunity for expansion. My long-term stock price target is $400 for Netflix.

Disclosure: I am long NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.