A Great Earnings Result Tomorrow may be a "Sell The News" Moment for Netflix (NASDAQ:NFLX)

When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 18x, you may consider Netflix, Inc. ( NASDAQ:NFLX ) as a stock to avoid entirely with its 62.3x P/E ratio.

When looking at P/E ratios, sometimes there is a justification for the high value, other times, it's just investor overconfidence.

Here we will examine Netflix's P/E, compare it to the industry and market, and see if it is a justified valuation metric.

Investors might also need to be aware, that sometimes traders may utilize a "sell the news" strategy after the earnings announcement, and use the higher volume to sell a larger position. That is why P/E can be a good metric to look at ahead of earnings.

In the chart below, we can see how Netflix's P/E compares to the market and industry.

Check out our latest analysis for Netflix

As we can see from the chart above, Netflix's P/E is quite above both the US Entertainment industry (43x P/E) and market (18.8x) levels. The industry rise may be associated with the recent increase in streaming service subscriptions and new infrastructure deployments by companies that are rolling out 5G services.

Importantly, we need to ask ourselves, " has Netflix gone beyond the high growth phase? ". For companies, this marks a period where the P/E converts from a gauge of investor sentiment to an appropriate metric for stock performance.

In that regard, we can observe that Netflix has been profitable for some time and recently turned positive free cash flows. While it is true that the company is still growing, the revenue growth rate has slowed in the last 12 months and competitors have intensified their streaming business.

This might be a good time to start looking at Netflix as a company that is stabilizing, and evaluate it also on a P/E basis.

Want the full picture on analyst estimates for the company? Then our free report on Netflix will help you uncover what's on the horizon.

What Are Growth Metrics Telling Us About The High P/E?

In order to justify its P/E ratio, Netflix would need to produce outstanding growth well in excess of the market.

Retrospectively, the last year delivered an exceptional 67% gain to the company's bottom line.

The latest three-year period has also seen an excellent 449% overall rise in EPS, aided by its short-term performance. Therefore, it's fair to say the earnings growth recently has been superb for the company.

Turning to the outlook, the next three years should generate growth of 28% per year as estimated by the analysts watching the company. That's shaping up to be materially higher than the 14% per annum growth forecast for the broader market.

With this information, we can see why Netflix is trading at such a high P/E compared to the market.

Even though investors are keen to see high growth, some of them may not see the same future for the company as they did a while ago and may decide to change course on their investing strategy. That is why investors need to be aware that there may be a different type of sentiment for Netflix moving forward.

So far, however, shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

Key Takeaways

It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator. 

Investors should also be aware that good news are not always necessarily a long signal ahead of an earnings call.

As investors, it is important to decide when to look at a company from the lens of the earnings performance as a relevant indicator for the stock. This will help prevent surprises and better risk management down the road.

Currently, Netflix can ve viewed both as a high growth company where the price to earnings does not matter yet, or as a stabilizing company that should also be assessed as such.

If investors deem Netflix to still be a high-growth stock that has most of its growth perspectives ahead, then it is premature to take P/E into account. However, if we see the company is stabilizing, than a 62.3x P/E may be concerning for investors.

You should always think about risks. Case in point, we've spotted 1 warning sign for Netflix you should be aware of.

If these risks are making you reconsider your opinion on Netflix, explore our interactive list of high quality stocks to get an idea of what else is out there.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com

Simply Wall St analyst Goran Damchevski and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.