Tags: Tesla | Netflix | bubble | PE

Why Stocks Like Netflix and Tesla Will Have a Horrible Crash

By    |   Monday, 28 October 2013 07:43 AM

I've lived and invested through many different bubbles and manias. I've learned that people never change as far as their investing habits. Why?

Greed takes hold of those without discipline and it clouds their thinking. They lose all rational thinking as the euphoria feeling in their emotions ends up being their downfall.

It doesn't matter if it was Internet and tech stocks back in 2000 or Chinese stocks and U.S. real estate back in 2007 and 2008. The masses act the same all throughout the years. Every five to 10 years, there is a "mania" that causes an irrational bubble in a sector or a stock . . . sometimes many stocks.

Well, right now, we're in that "mania mode" once again with two stocks in particular: Netflix (NFLX) and Tesla Motors (TSLA).

There are two easy ways to always spot a mania that forms a bubble that will allow you to steer clear of them and not be in them when the bubble bursts and enormous investor losses mount up.

1. Look at their charts. When a stock's chart goes parabolic and forms a very steep angled climb, you can be sure a mania is underway that is forming a bubble in that asset. It will seem like the stock defies gravity and can do no wrong. Every day it seems to go up. And when it does have a pullback, the pullbacks are typically very shallow. Then, you know that the bubble is very mature and runs the risk of popping when it gets very extended away from its 200-day moving average.

2. The second way to know when a stock is way out of whack with what it should be priced at is to look at its fundamental valuations. You see, with every "mania" you'll always hear why valuations don't matter in their case, but just know that fundamentals ALWAYS matter. The stock may just take a bit longer to reflect reasonable valuations, but they will come.

One easy fundamental metric to look at is to compare the stock's price with that of the company's earnings. A typical company will have a price-earnings (P/E) ratio between 5 and 20. The lower this number, the greater value you've found. The higher the number, the more lofty the valuation.

Now, occasionally, a very fast-growing company can sustain a larger P/E for a period of time, like a P/E of 25 to 45. It can't do it forever, but it can do it for a season of the company's growth phase if the growth is at a well-above-average clip.

Ok, with that in mind, let's take a look at the P/E's of Netflix and Tesla.

There are two ways to evaluate a company's stock price relative to its earnings: the trailing P/E and the forward P/E.

A trailing P/E use what the company has produced in earnings during the previous 12 months. The forward earnings uses what the company is expected to earn during the upcoming 12 months.

Ok, let's start with Tesla. It has no trailing P/E because there were no earnings made. So the "E" part of that ratio wasn't even there. So investors were running up the price of a stock that didn't even earn money.

But they're supposedly doing this for what the company will earn. So that's where the forward P/E becomes very important. It does have a forward P/E because it is making some money now and is expected to during the next 12 months.

So when you divide the stock's price by its annual expected (forward) earnings, you get a P/E of 99! Therefore, for every $1 in earnings that Tesla makes, investors are willing to pay $99 for that $1 in earnings.

Now, remember that investors typically pay $5 to $20 for $1 in earnings, and on occasion they'll even pay something much higher like $25 to $45 or so for each $1 in earnings if the pace of the company's earnings is on a very steep trajectory higher.

Well, investors are paying twice as much as the high end of what investors typically pay for faster growing growth stocks. So since the stock price is outgrowing the earnings pace at such a fast clip, I expect the stock price to at least cut in half at some point between now and the next six months. Tesla investors are going to be "crying the blues."

Ok, what about Netflix? Netflix has a trailing P/E of 401! And a forward P/E of 94! Since its stock price has SO run ahead of its earnings to this degree, I fully expect Netflix to eventually lose 1/3 to ½ of its stock value!

Now, the tricky part about manias is that they don't make rational sense and so that's why a bubble forms in the first place. So judging exactly when these irrational bubbles pop is a bit more difficult. But it's easy to know when the "handwriting is on the wall" and to steer clear of them ahead of time by looking at how quickly the stock price is going up (the angle of the chart's trend) and by assessing the stock's price relative to the level of earnings that the company puts out.

Insanity can remain for a while, but eventually, the "day of reckoning" comes and the stock prices come crashing down to a level that is more in line with what the stock should have been trading at relative to its earnings in the first place.

So be wary of stocks like Netflix and Tesla from this point. They are ticking time bombs and will explode soon.

Is this the top? Could it go up further? These are questions that roam through investors' heads. But the real thought that should be in your head is that you want to be out at these ultra-high levels because when the crash begins, you won't be able to get out in time to retain the bulk of your gains (if any of the gains).

God bless!

About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust.
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I've lived and invested through many different bubbles and manias. I've learned that people never change as far as their investing habits. Why?
Monday, 28 October 2013 07:43 AM
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