The 3 Things Netflix Investors Need to Know Now

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Today's off-schedule (courtesy of the government shutdown) release of the September employment report proved disappointing, with the economy adding just 148,000 jobs last month. That's not the sort of number that will return the U.S. to full employment (though the unemployment rate did tick down to 7.2%), but it will certainly contribute to persuading the Fed not to begin tapering its monthly bond purchases this year. That may have had something to do with stocks hitting a fresh all-time high today, as the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average finished up 0.6% and 0.5%, respectively.

Shares of streaming film and TV provider Netflix hit an all-time high near $400 intraday on the strength of yesterday's third-quarter earnings report -- before ending the day with a 9.1% loss! Here are three key lessons for shareholders at the end of an extremely volatile trading session.

1. Netflix shares are almost certainly overvalued at today's prices.
In the third-quarter earnings letter, CEO Reed Hastings made himself pretty clear on this topic, by drawing on a historical analogy:

In calendar year 2003 we were the highest performing stock on Nasdaq. We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003.

In the earnings call, Hastings went further in emphasizing his concern:

Every time I read a story about Netflix is the highest appreciating stock in the S&P 500 it worries me, because that was the exact headline that we used to see in 2003. You can definitely -- we have a sense of momentum investors driving the stock price more than we might normally.

Let's be clear: Momentum investors aren't investors at all. They are punters, pure and simple. Their preoccupation is not with the underlying business, but with the strength of the stock's behavior. If their influence on the stock is excessive -- as Hastings suggests is the case -- it's likely that the stock valuation has become unmoored from the fundamentals of the business. In other words, it's a good bet the shares are now overvalued.

That's not hard to believe when you look at the multiples at which they trade: Try 125 times next 12 months' earnings-per-share estimate! It's even more credible when you look at the prevailing valuations among some other technology shares. Netflix competitor trades at 206 times its forward earnings-per-share estimate!

2. Shareholders should be prepared for a wild ride: A near-term correction (within the next 12 months) is more than possible.
Today's volatile session for Netflix shares -- the stock was up as much as 9.6% before ending the day down 9.1% -- is a taste of what investors can expect in the near future.

This follows directly from the first observation; indeed, an overvalued stock tends to be volatile. Sometimes it's volatility on the upside, as it becomes even more overvalued; however, the longer that momentum persists, the more likely it is a correction will occur to bring the share price back in line with its fair value. I don't know when this will occur with Netflix; I can't even say that it is certain to occur, but it looks increasingly likely, at this stage.

Hastings' aforementioned comments and an analyst note by Bank of America Merrill Lynch that called the stock's valuation into question were catalysts for today's decline. The disclosure by billionaire investor Carl Icahn after the market close that he has sold half of his Netflix stake -- he sold 2.4 million shares today alone at $341.44 -- is another catalyst that could put pressure on the stock in the near term.

As I wrote yesterday in referring to Hastings' historical analogy, "in 2004, the year after it had been the highest-performing stock on the Nasdaq, Netflix was the worst-performing stock of any current Nasdaq component, handing shareholders a stunning 55% quotational loss."

If you're a long-term shareholder, you need to buckle up!

3. The good news: Netflix is led by an unusual and exemplary CEO.
Hastings isn't the sort of chief executive who is happy to see his stock price go as high as momentum investors will push it; instead, he'd prefer it to remain within striking distance of its fair value. Better yet, he's willing to say so openly. Finally, he knows that, beyond his comments, there is little he can do to influence the share price, and his focus remains on the things that he can control: building a service that his customers love and an enduring brand.

These are the traits of an exceptional leader, and that bodes well for the company's potential for long-term value creation. Long-time shareholders ought to be delighted about that, and it should help steel their nerves to continue holding the shares for the long term. For prospective investors, however, there will probably be better opportunities to get on this train over the next 12 months.

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Fool contributor Alex Dumortier, CFA, has no position in any stocks mentioned; you can follow him on Twitter: @longrunreturns. The Motley Fool recommends and owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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