A Tale of Two Tech Stocks

I have seen some pretty strange things over the course of my 30-year career as a stockbroker and financial advisor. Although investing in the stock market is generally regarded as an exercise in financial acumen, at times it can be more of a measure of the extent to which emotion trumps logic.

For example, like many of you I was puzzled by the mania that enveloped dotcom stocks in the late 1990s, only to see most of them implode shortly thereafter. I figured that would teach everyone a good lesson, as the magnitude of those losses creates the kind of pain that never fully goes away.

Or maybe not, given the recent performance of Netflix (NASDAQ: NFLX), which has seen its share price balloon by more than 90% during the past twelve months – with more than a third of that increase occurring over the past thirty days. Its recent share price of $124 places its value at $53 billion, about midway through the cap-weighted S&P 500 Index.

Don’t get me wrong, I’m thrilled to see successful companies rewarded with a higher valuation for their equity. After all, that’s what capitalism is all about. But I get nervous when I see so much money pouring into a stock that has not yet proven its ability to deliver consistently high profits such as Netflix, which is currently trading at more than 400 times NEXT year’s earnings.

I am equally concerned when I see a company that has proven its ability to generate excellent results punished with a lower valuation, such is currently the case with Apple (NASDAQ: AAPL) which has seen its share price deflate by more than 10% over the past couple of weeks. Yes, it is still the most valuable publicly traded company in the world with a market cap of more than $650 billion. But at a recent price of $115, Apple is valued at less than 12 times next year’s earnings, which is less than the average for the entire S&P 500 Index.

That discrepancy would be easier to digest if there was compelling empirical evidence to suggest that the fortunes of both companies were about to reverse, but that does not appear to be the case. Apple maintains a healthy profit margin of more than 22%, while Netflix comes in at a scant 3%. Netflix did see quarterly revenue growth of 23%, which is impressive, but not nearly as impressive as Apple’s 37% growth rate.

That being the case, perhaps we need to look farther out in time to justify the extraordinary difference in valuation between these two businesses. Similar to the dotcom bubble of fifteen years ago, the only viable rationalization for assigning such an optimistic value to Netflix is the potential for future earnings several years hence. I’m okay with that too, provided those projections are based on something other than a straight line extrapolation of a recent trend.

Unfortunately, the projections I have seen for Netflix include extrapolations based on assumptions that are little more than guesses. As to how successful Netflix will be at creating popular content in the future; who can possibly know that? And how much money will consumers be willing to pay for it given the alternatives available at that time? The answer to that requires an understanding of precisely how technology, content delivery and consumer preferences will evolve over time.

But even if you accept those projections, they still need to be valued at a reasonable rate. For that, legendary mutual fund manager Peter Lynch would consult his “PEG ratio”, which compares the Price to Earnings ratio for a company to the trailing five-year average Growth rate of those earnings. If the ratio is less than 1.0, that suggests earnings are growing at a faster rate than the market is valuing them, opening up the potential for future appreciation.

In the case of Apple, its PEG ratio is about 0.9, indicating it may be undervalued. But the PEG ratio for Netflix is above 24, meaning investors are effectively betting that the company can grow its future earnings at a pace almost 27 times the rate Apple will be able to grow its earnings. For that to be true, you and I will need to be glued to our televisions, laptops, notepads and smartphones watching almost nothing but content provided by Netflix for the rest of our lives! Of course, I don’t believe that is going to be the case, but you have to approach that level of credulity to justify the current stock price for Netflix.

A more likely explanation is that some very nervous investors are moving in and out of both stocks simultaneously, causing temporary disruption to the equilibrium pricing of each company. It is worth noting that 90% of Netflix stock is held by institutions and insiders, leaving only 10% of “float” trading in the open market. In contrast, only 63% of Apple’s stock is owned by institutions and insiders, making it less susceptible to extreme swings in value.

The scary thing about owning a momentum stock like Netflix is that you never know when that momentum is about to reverse. In fact, exactly four years ago Netflix’s share price was in the process of dropping 75% in value, and over the past two years it has twice declined by at least 20%. In all three cases the price acceleration leading up to those skids was less extreme than it is now.

Meanwhile, Apple finds itself in the opposite situation. The few times its share price has declined more than 5% over the past two years, it has always come back with a vengeance. That doesn’t necessarily mean it will do that again this time, but given all those facts I’d much rather own Apple than Netflix at the moment.

As many viewers of the popular Netflix program “House of Cards” have asked themselves many times over, how does this all end? I don’t know the answer to that, but I do know that the stock market has a funny way of evening things out. If you currently own Netflix, at the very least I suggest you place a stop sell order beneath it to protect most of your gain. And if you don’t yet own Apple, this may be the perfect time to buy it before it launches the next phase of its ascension towards becoming the world’s first trillion dollar company.