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If you are feeling a little gun-shy about equities these days, given the strong performance over the past two years, we recommend you sell or short NYSE Euronext (NYSE:NYX), one of our most dan­ger­ous stocks.

Stock exchanges have been very profitable enterprises for most of their history. As more and more trading is electronic and is directed by computers, the exchanges struggle to maintain profit margins. There is little value to add as an exchange in today’s environment. Today’s announcement that NYX’s fourth-quarter net profit dropped 21% from a year earlier to $120 million, or 46 cents a share, is no big surprise -- and it is likely the beginning of a trend where NYX struggles to regain the profits it enjoyed in years past. This company’s best days are behind it. Some of the worst days for the stock are yet to come.

Like all of our most dan­ger­ous stocks, NYX has:

  1. Mis­lead­ing earn­ings = account­ing prof­its are pos­i­tive and ris­ing; while true, eco­nomic prof­its are neg­a­tive and falling.
  2. High val­u­a­tion = very high expec­ta­tions embed­ded in the cur­rent valuation.

Specifically on “mis­lead­ing earn­ings”: NYX reported a $957mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $641mm -- a dif­fer­ence of $1,599mm, or 34% of 2009 revenues during the last fiscal year. The majority of this disconnect comes from asset write-offs of $1,249mm, which equals 12% of reported net assets. Given that management is supposed to create value, not destroy it, writing down $0.12 for every $1 on the company’s balance sheet does not bode well for its ability to create shareholder value. Our recent article on Management Failures explains why investors need to beware large asset write-downs like those incurred by NYX.

Specifically on the stock’s high valuation: Our discounted cash flow analysis of the current stock price of around $33 shows NYX must grow its net operating profit after tax (NOPAT) at over 11% com­pounded annu­ally for at least 30 years. A 30-year growth appre­ci­a­tion period with an 11%+ com­pound­ing growth rate sets expectations for future cash flow performance quite high. Historical growth rates are much lower. In addition, the stock’s upward movement is handicapped by the current outstanding stock option liability of $8mm, about 1% of its market value. If the stock price climbs, that option liability grows larger as all of the outstanding stock options move more in-the-money and become more valuable.

Over­all, the risk/reward of invest­ing in NYX’s stock looks “very dan­ger­ous” to me. There is lots of down­side risk, given the mis­lead­ing earn­ings; there is lit­tle upside reward, given the already-rich expec­ta­tions embedded in the stock price.

In a business where investors make money by buying stocks with low expectations relative to their future potential, NYX fits the pro­file of a great stock to short or sell.

Source: Hedge Against a Market Sell-Off; Sell NYSE Euronext