If there was any single financial concept I think investors should remember, it is the one above. The more investors bid up a stock’s valuation, the less room the company has for error. When a highly valued company does disappoint, the drop in a stock’s price can be significant. Netflix (NFLX) and Amazon.com (AMZN) are two examples.
Netflix has been a poster child of how poor management decisions can 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.
Shares of Amazon.com lost 11% of their value yesterday after missing third-quarter earnings expectations and 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.
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.
The Week Ahead
More than 100 S&P 500 member companies will report earnings next week. Included in this group are Dow components Pfizer (PFE) and Kraft (KFT), which report on Tuesday and Wednesday, respectively.
The week’s first economic report will be the October Chicago PMI on Monday. Tuesday will feature the October ISM manufacturing survey and September construction spending. The October ADP employment report will be published on Wednesday. Thursday will feature the first estimate of third-quarter productivity, the October ISM non-manufacturing survey, and September factory orders. October employment data, including the change in nonfarm payrolls and the unemployment rate, will be published on Friday.
The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. The meeting statement will be published earlier than usual on Wednesday, at 12:30 p.m. ET. About two hours later, Federal Reserve Chairman Ben Bernanke will hold a press conference at 2:15 p.m. E.T.
Atlanta Federal Reserve Bank President Dennis Lockhart is the only other Federal Reserve official scheduled to make a public appearance. He will speak on Thursday.