Rotblut: High Valuations and High Downside Risk

Netflix and are two good examples as to why you should be cautious about investing in a highly valued stock. Shares of both companies fell significantly earlier this week after disappointing investors.

Granted, Netflix has made some very publicized mistakes (which I’ll get to in a moment) and Amazonmissed earnings estimates, but the impact their valuations had cannot be ignored.

The reason is: High Valuations = Greater Expectations = More Downside Risk

The more investors think a stock is worth, the less room the company has for error. Stock prices get bid up on the expectation of good news. When the news stops living up to expectations, share prices fall. It is a scenario that has been repeated time and time again. Netflix and are two of the latest examples.

Bad Decisions for Growth Company

Netflix has been a poster child of how poor management decisionscan simultaneously anger both customers and shareholders. As many of you know, the company has been stumbling since July when it announced separate price plans for DVD rentals and online video streaming. (The stock’s price-earning ratio at that time was a pricey 85.) In September, CEO Reed Hastings threw gasoline on the fire by saying DVD rentals would be split into a separate business named “Qwikster.”

This past Monday, Netflix surprised shareholders yet again. The company reported a decline in unique domestic subscribers; in other words, customers canceled their subscriptions. Investors reacted by sending the stock down 35% on Tuesday.

The chart below shows just how much shares of NFLX have fallen. Note that how the upward price movement prior to July 2011 in no way forecast what has happened since mid-July.

Strong Profits Wanted Now, Not Later

Shares of lost 12.7% of their value on Wednesday after missing third-quarter earnings expectationsand giving disappointing profit guidance. Investors were unnerved by the company’s expenditures, such as the money spent on increasing the number of fulfillment centers. Amazon’s new Kindle Fire tablet computer, which was launched last month, also increased costs.

The spending may boost future profits, but with a price-earnings ratio of 103, investors wanted good earnings numbers now. It’s a classic case of a slim margin for error caused by high expectations.

Buyers Will Eventually Stop Buying

None of this is to say that a highly valued stock can’t rise even further, but rather that with each move higher, the risks also increase. If you are going to ignore a high price-earnings ratio (or a high price-to-book ratio), be cognizant of the potential downside. Eventually, there will be a time when would-be buyers refuse to pay a higher price for the stock.

Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.