High Valuations = Greater Expectations = More Downside Risk.
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 (NASDAQ:NFLX) and Amazon.com (NASDAQ: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.”
During earnings season, Netflix (NASDAQ:NFLX) surprised shareholders yet again. The company reported a decline in unique domestic subscribers; in other words, customers canceled their subscriptions. Investors reacted by immediately sending the stock down over 35%.
Shares of Amazon.com (NASDAQ:AMZN) lost 11% of their value immediately 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.
Tyler Durden is the founder of Zero Hedge.