3 Reasons Why Netflix, Inc. (NFLX) Is Risky At Current Valuations

Netflix, Inc. (NASDAQ:NFLX) poor run in the market shows no sign of slowing down as investors continue to react to waning growth prospects on the international front. Even though a cautious second quarter outlook remains a point of discussion, there are underlying problems that continue to evoke valuation concerns.

Overvaluation concerns compounded by free cash flow problems amidst a fiercely competitive environment are some of the challenges the company is grappling with.

Overvaluation Woes

Netflix, Inc. (NASDAQ:NFLX) boasts of a rich valuation even as it continues to grapple with free cash flow woes. A high price to sales ratio of six continues to spook investors, seen by recent selloff. A stock trading at 346 times trailing earnings and 87 times forward earnings is by no means any cheap.

The streaming giant boasts of excellent revenue growth rates that have risen from $4.374 billion in 2013 to 2015 highs of $6.779 billion. However, when it comes to profit margins, it is a completely different story. The company’s net earnings are by all standards a shadow of what investors have come to expect from a company of its status.

Given the mounting overvaluation concerns Netflix, Inc. (NASDAQ:NFLX) remains’ vulnerable to decline on missing the Street expectations.

Free Cash Flow Problems

Netflix valuation concerns are further exacerbated by the fact that it has negative free cash flow from operations. Operating cash flow dropped from $97.8 million in 2013 to negative cash flow of $749.4 million in 2015. A company with a market cap of $40.8 billion according to many investors should not be trading with a negative cash flow.

There is no clear answer as to how the Street can value a company with no tangible assets and solid cash flow. Netflix, Inc. (NASDAQ:NFLX), as it stands, continues to trade as a speculative growth stock rather than a conservative investment. Given that the stock is priced to perfection any concern on the company’s ability to deliver on expectations will always spook investors fuelling sell off reaction.

Speculative growth stocks are synonymous with robust revenue growth metrics. Such stocks always stand the risk of trading lower in the market in case the momentum in fundamentals starts to break down.

Netflix’s international expansion drive has eaten into the company’s cash reserve without having any significant impact on returns. Given that expenditure on the international front continues to soar amidst tapered growth investors are increasingly starting to question the stock’s valuation.

Competition Threat

CEO, Reed Hastings, has done a nice job in positioning Netflix as the juggernaut of the streaming business. No one could have ever imagined of the kind of disruption the streaming company would have on cable satellite and broadcast companies that have operated as a monopoly over the years. Even on affirming its position, the company faces a much bigger threat in the form of competition as more companies start to stream content.

Amazon.com, Inc (NASDAQ:AMZN) poses the greatest threat to Netflix prospects given its financial muscle and willingness to go the extra mile all in pursuit of market share. Competition is the last thing that the streaming giant needs now, given its suppressed profit margins.

Long’s law clearly states that free cash flow will most of the time tend towards the inverse of the number of competitors in the industry. Amazon’s bolstering its efforts compounded by other cable companies also looking to expand into the streaming business should spell more trouble for Netflix.

Netflix, Inc. (NASDAQ:NFLX) has enjoyed a premium valuation of the fact that it faced minimal competition in the space. With the likes of HBO Amazon and Hulu, bolstering their efforts there is no reason as to why it will continue enjoying such a high valuation.

Bottom Line

Up until now, investors have been carried by the story that Netflix, Inc. (NASDAQ:NFLX) is a universal platform that is infinitely scalable. However, recent realization of what the future holds amidst fierce competition and growing content costs has all but continued to erode investor’ confidence.

A lack of a clear path on how Netflix intends to tackle competition to affirm its dominance should continue to evoke valuation concerns going forward.

Viraj Shah

Viraj Shah has completed M.Com (Finance) and is currently pursuing his CFP. He tracks US markets along with other global markets like India very closely. He is very passionate about stocks, real estate, and technology. He also believes that money can always be made in the market.

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