Smart Investing Daily – Use This Professional Trader’s Technique to Find Value

Jared Levy, Editor, Smart Investing Daily
Tuesday, 15 February 2011

stock index For the past 17+ years, I have followed the financial markets and studied their behavior. One of the main reasons I fell in love with the marketplace was the fact that not only can you control your own destiny so to speak, but every day is new and exciting. Each new trading day brings with it new surprises and challenges to learn and potentially profit from. The financial market is an ever-evolving creature that many try to tame and often fail.

Even with all the change happening day in and day out, there are still some fundamental “rules and guidelines” that govern the actions of the “beast.” To prevent disaster, you need to spot major deviations in these guidelines and have an action plan.

Don’t get me wrong; there are no black-or-white guidelines when it comes to buying or selling a stock. Anyone who tells you X price is the exact buy level and Y price is the exact sell level probably has a bridge they can sell you as well.

I’m talking about rational, collective value reasoning. Masses of professional traders tend to have similar beliefs and if you know what they are you can use them to your advantage.

Let me explain what that means.

Finding “Value”

Both Sara and I have talked about these concepts in the past. Generally, both of us use some sort of common (or sometimes unique) gauge to measure both the fundamental health of a company and perhaps we examine the chart patterns of its price to decide when to buy or sell.

Sara wrote a great article on some ways to check for value in a company back in September 2010. Back then, we both thought there was serious upside opportunity in many areas of the stock market. Here are my notes on valuing the markets back in October.

Fast-forward five months and +33% later in the S&P 500 (SPY), and now finding value may be a bit more difficult…

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

Financial Markets Are Forward Looking

The stock market is a leading indicator of the economy and of future value of the companies that are traded within it. Basically, the stock market has a six to 12 month future telescope that it looks through. If the market thinks that a company is going to make more money in the future, traders will often buy the stock now in anticipation of that event.

Earnings reports and news releases are “checkpoints” along the way to make sure that the stock is behaving the way the market anticipates; they help traders “rationalize” their forward-looking thesis. If those checkpoints offer disappointing news, stocks may go down; if the checkpoints offer positive surprises, the stocks may go even higher.

Traders have many ways of evaluating whether a stock is a buy or a sell. There are several common measurements that traders and investors use to confirm their collective thought process. If those measurements are strong, then the market may collectively rationalize an increase in a stock’s price and vice-versa. But what happens when price gets too far ahead of those expectations? Here is one method you can use.

Rationalizing Netflix With a Simple Guideline

One of the most common measurements of value is not the price of the stock itself, but something called the price-to-earnings ratio (P/E ratio). It’s very simple; you take the price of the stock and divide that by amount of money that a company is earning per share in a year’s time. Netflix, Inc. (NFLX:NASDAQ) earned $2.96 per share over the last four quarters. With Netflix trading at an all-time high of $246, it is trading at 83 times annual earnings. That is super HIGH! The higher the P/E, the more expensive the stock and vice versa.

The average P/E ratio of the S&P 500 index over time is about 16 times earnings. (The normal range is about 14-20). Now in all fairness, analysts expect Netflix to earn more money next year, they expect that P/E to drop to about 56 times… Still very high!

You don’t have to be good at math to know that 56 is extremely elevated compared to a market average of 16. Even the great Apple (AAPL:NASDAQ) is only trading at 20 times its past year’s earnings; Google (GOOG:NASDAQ) at about 23 times. So by this measurement alone, Netflix is extremely overpriced.

Let’s not forget that Netflix actually missed on its revenue expectations and gave a weaker revenue growth outlook for the future. So I still cannot understand why investors are pushing this stock to nosebleed levels. But irrational behavior is not uncommon; you just have to recognize it.

When I am unable to “rationalize” selling or buying a stock (in the case of Netflix), I simply walk away or perhaps take the opposite view.

Should You Buy Netflix Here?

As cool of a business model as it has and as much as I can see its revenue growing, there could be a rubber-band effect forming here. When a stock starts to run too far ahead of its earnings and the market, you can imagine it stretching a rubber band further and further. At the first sign of weakness, the rubber band can snap back into place, which would bring Netflix lower in this case.

The basic reasoning for the recent run-up is the expectation that Netflix will add subscribers to its high-margin streaming video service. To be fair, it did add 5.65 million customers last quarter. But its streaming service is not without faults or competition, and you will be hard-pressed to find the latest blockbusters in its streaming lineup.

Frankly, based on the charts, I wouldn’t be surprised if we saw Netflix return to the $205-$210 level in the next month or so, down from current levels at around $247. There are other indicators in the charts that also point to a short-term pullback. Use caution if you are looking to go long here.

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