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Why Netflix Is Too Good to Be True


Investors beware -- what goes up, must come down.

It's hard not to love Netflix (NFLX). If you use its home delivery and streaming video movie rental services, you know that the company delivers great products that keep it streaks ahead of companies like Blockbuster (BBI) and Coinstar (CSTR).

Priced north of $71.00, its valuation, on the other hand, is another thing. As lovable as the company may be, its stock price has gotten way ahead of itself.

Boosted by new platform partnerships, including ones with Sony's (SNE) PlayStation 3 and Nintendo's Wii gaming devices, and the possibility of a mobile application for Apple's (AAPL) iPhone, Netflix shares have shot up 45% since the end of January.

Now trading at $71, Netflix has a market valuation of $3.8 billion. At 2.5 times sales revenues, 35 times forward earnings, and more than 30 times free cash flow, I'd say the stock is now pushing into nosebleed territory.

To get a firmer idea of what investors are getting themselves into, I've been working on a three-scenario discounted cash flow model, which also suggests that buyers are paying too much these days.

My rosiest forecast shows that Netflix will achieve free cash flow of $120 million next year, and will grow that number by 20% over the next four years, then by 10% through year 10, and 2.5% for years 11 through eternity. I've also assumed a discount rate of 10.5%.

This scenario -- which demands an awful lot of growth over the next few years -- generates a share valuation of $74, which isn't far from where Netflix trades today. In other words, stock is almost priced for best-case scenario growth.

My middle and low estimates, which assume growth of 15% and 10% over the next five years, 10% and 7% for years six through 10, 5% and 2.5% for the remaining years, give share values of $61 to $45. Most investors would regard growth figures in both cases as fairly impressive.

Of course, it could happen, and I'm more focused on what Netflix must do to warrant its current price than trying to pin down a target price. But, even if Netflix does manage to deliver these numbers, it won't be enough to justify its price tag.

For those who believe that Netflix can grow its free cash flows at 20% per year for the next five years and at double digits for five more years after that, there might be a tad more value left in the shares. But I have my doubts.

Of course, Netflix has an ability to defy bearish arguments and regain momentum. Views that the stock is overvalued often get trumped by market buzz surrounding the stock. Indeed, I wouldn't be surprised if market momentum takes the stock a few points higher over the coming weeks.

Then again, momentum stocks -- especially richly valued ones like Netflix -- are rarely safe investments. Even a small slip in market sentiment could slam the stock into reverse. Momentum chasers, please take care.

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No positions in stocks mentioned.
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