The price-to-earnings ratio, or the P/E ratio, is perhaps one of the most quoted and well-recognized valuation metrics in equity analysis. As a rule of thumb, value investors tend to seek out companies with low P/E ratios. Benjamin Graham in his book Security Analysis prescribes a P/E of less than 16 for defensive investors, while aggressive investors seeking growth may opt for companies with higher P/Es. Because of its ubiquity and prominence in fundamental equity analysis, it is imperative that the budding investor is able to understand and calculate P/E ratios for any stock. This article will focus on the calculation of the trailing twelve-month P/E (TTM), forward P/E, and the analysis of the P/E in regards to Netflix, Inc. (NFLX).
Trailing Twelve-Month (TTM) P/E
The numerator of the P/E ratio is the current price of the stock (P), while the denominator (E) is the earnings-per-share or EPS. EPS is a ratio in and of itself and breaks earnings down by the company’s shares outstanding. Earnings per share for a company is usually calculated as follows:
(net income – preferred (net income – pre dividends) / weighted average number of diluted outstanding shares = EPS
Together, the price divided by the EPS result in the P/E, which reflects how much investors are willing to pay per one dollar of a company’s earnings. The price portion is easy enough—one needs to simply pull up Netflix’s price on any given day. Once the numerator has been attained, it is time to calculate the denominator. Fortunately, instead of calculating EPS by hand, companies are required by the SEC to report this ratio in their quarterly Form 10-Qs and annual 10-Ks.
When analyzing EPS there are a few caveats to keep in mind. EPS is a breakdown of the company’s earnings by outstanding shares. Outstanding shares can be a relatively fluid component of EPS that can change with several factors. If shares outstanding increase, EPS will decrease and vice versa. Companies can issue or buyback shares as part of a management strategy. EPS is also typically calculated and reported using diluted shares which take into account any convertible shares that may be issued through bonds, warrants, employee benefits or otherwise. Thus, this provides for even greater volatility of outstanding shares. Lastly, companies may report both a non-GAAP and GAAP EPS with the higher of the two usually gaining media attention. Data providers can disseminate reports based on either non-GAAP or GAAP so it can be important to know which is being used.
Now, let’s take a look at Netflix’s reported EPS for the last four quarters through October 2018. Netflix provided third quarter 2018 earnings on October 16 with no EPS adjustments. GAAP earnings for the past four quarters are the following:
- Q3/2018: $0.89
- Q2/2018: $0.85
- Q1/2018: $0.64
- Q4/2017: $0.41
Summing these up we get TTM EPS of $2.79. Taking Netflix’s closing price as of October 24, 2018 of $305 and dividing by EPS ($305/2.79) we get 109.3. Therefore, NFLX’s TTM P/E ratio as of this writing is 109.3, in other words, investors are willing to pay $109.30 per $1 of NFLX’s earnings.
While TTM P/E calculations are objective measures based on historical data, forward P/Es are subjective calculations as they take into account a company’s projected earnings per share growth. The growth rate can be inferred through several means, such as, management’s guidance, historical growth rates, industry prospects and growth models based on fundamentals, such as return on invested capital. All these methods are beyond the scope of this article, and for the sake of brevity, we will use the consensus growth rates as estimated by the many analysts that already cover NFLX.
Looking ahead to 2019, we see that analysts have an average EPS projection of $4.21. Keep in mind that the forward P/E also uses the current price of the stock in the numerator. Thus, calculating the forward PE requires the following calculation: $305/$4.21. This results in a forward PE of 72.50. As is typically the case, the forward PE is lower due to a higher EPS expected in the future.
Analysts with access to a broader set of stock data will often look at the historical PE annually over time. Historical PEs in conjunction with the forward PE can provide a range of PE levels expected for the stock. In this analysis our PE range only includes TTM and forward or 72.50 to 109.30. This provides us with insight on what investors are willing to pay in the equity market for $1 of Netflix’s earnings.
PE values can be more clearly analyzed by also looking at a company’s competitors. Certain industries overall may have PE trends that are important for an investor to understand so the industry average PE can also be helpful. Below we look at the TTM and forward PE for some of Netflix’s competitors as well as the FAANG group.
|Name||Ticker||$ Price||TTM P/E||Forward P/E||P/S|
|Alphabet Inc. A||GOOGL||1,057.05||44.73||22.78||5.88|
|Comcast Corp A||CMCSA||34.12||6.50||12.12||1.74|
|Facebook Inc A||FB||146.11||22.17||18.38||8.83|
Values for Netflix’s comparative analysis vary widely so also included is the average and the P/S. Here we see that Netflix has the second highest TTM PE and the highest forward PE. Looking at some growth data for the first three quarters of 2018 (See also: How to Analyze Netflix’s Income Statement) we see that revenue has been growing at a 25% rate and earnings are expected to grow at a 50% to 100% rate. Netflix also has one of the highest PS ratios. In some cases a reasonable PS can drive a higher PE if sales are expected to grow but the company has high capital expenses detracting from the bottom line. With Netflix both the PE and PS are quite high and the highest of their peer group indicating overvaluation. Although both revenue and earnings are growing substantially it could be likely for the stock to potentially flat line at these levels. Analysts seem to be of this opinion as the one-year target price is a relatively conservative $398.