What Makes Netflix And Tesla Hot Stocks?

Netflix and Tesla have become the most recent stock market darlings. Almost every day they set new all-time highs as investors expect great things from these companies. With the recent price movements, Netflix and Tesla follow in the footsteps of companies like Apple and Priceline which also have seen their stock prices shoot up in recent years. But, besides the obvious fact that investors expect a very, very, bright future for these companies, what other characteristics do they share?

Performance of Hot Stocks

To find out I looked into a selective number of companies that satisfy the my description of 'stock market darling' or 'hot stock'. They are, in alphabetical order, Apple (AAPL) , Amazon (AMZN), Google (GOOG), LinkedIn (LNKD), Netflix (NFLX), Priceline.com (PCLN), Tesla (TSLA) and TripAdvisor (TRIP) . Yes, this is a very arbitrary list, but then again there is no good or bad way of doing this. Besides stock price performance in recent years (since the financial crisis) I incorporated aspects like media attention, a high-profile and groundbreaking business strategy and size. Concerning the second aspect, it is no coincidence that most of the selected companies have operations that are internet-related. I took size into account to make sure only companies are included that are loved by the bulk of investors. There are of course loads of small cap stocks, like biotech or mining companies that hit the jack pot, but these companies are not widely acknowledged as stock market darlings.

Let's put things into perspective. In the graph below I have plotted the stock price performance of the eight companies mentioned above. Since not all stocks are equal, I established the time period that captures their biggest rally for each individual company. The length of these periods can differ quite a bit as the graph points out. For instance, Apple saw its stock price rise from below USD 100 to over USD 700 between January 2009 and September 2012. After that investors started doubting if the dominance of the iPhone and IPad were to last and the stock came down pretty hard. Priceline.com on the other hand started a rally after the financial crisis that has not faded until now. This is still a hot stock as its price has already risen 16-fold! Also, take note of the share price performances of Netflix and Tesla. Despite their relative short 'rally periods', which are ongoing, their returns have been massive. While it took Apple three and a half year to rise sevenfold, Tesla has done this in less than one year!

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Valuation

Now that the stock price performances of the selected companies are made visible I take a look at some of their characteristics. The next graph shows the average market cap (thus also incorporating the relative low market caps at the start of their rallies) of the eight companies. Two giants stand out; Apple (for some time the largest company of the world) and Google, with average market caps during their rally period of over USD 200 bln. The smallest company is TripAdvisor which had an average market cap of USD 7.3 bln., which is still pretty significant. The average market cap of the eight stocks is USD 82 bln., underpinning their status as stock market darling for a large group of investors.

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What about valuation? The graph below depicts the average PE ratio during their stock price rally. I used realized earnings instead of forward earnings. It is a given that investors expect tremendous growth for all of these companies, which will undoubtedly be reflected in earnings estimates. Realized earnings omit these expectations but at the same time give an indication of how much investors are willing to pay up.

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The results are probably no surprise. All of the eight companies had an average PE ratio above that of the S&P 500 index (SPY). In some cases valuations have been extreme for years. Since May 2011 LinkedIn has been trading on an earnings multiple of 900. Netflix and Amazon are 'modest' second and third with PE ratios of 234 and 216. Apple is probably the only reasonable exception with an average PE of 17, which is not that much higher than the average PE ratio of 15.5 for the S&P 500 index. Hot stocks are expensive, no doubt about that.

Now, when companies are expected to grow tremendously investors are probably willing to pay a high price multiple. The company is expected to grow into the rich valuation, which then comes down, right? Wrong. All of the eight companies had a higher PE ratio at the end of the rally then at the start. And by higher I really mean much higher. Take Amazon which had a PE ratio of 37 in January 2009. Currently, investors are willing to pay 700 times Amazon's latest earnings. Priceline.com went from a PE ratio of 19 to over 70 now. So, unlike what might be expected, hot stocks tend to get more expensive in their years of glory.

Sales and earnings growth

Next, let's turn to some company fundamentals. The graph below reveals that the eight stock market darlings experienced very strong sales growth. On average 159% to be precise. This is, however, heavily distorted by the sales growth numbers of Tesla, which are pretty extreme (1100%). However, excluding the Tesla numbers would still leave an average sales growth for the remaining companies of 37%. Google experienced the slowest average growth of its sales of 22%, still comfortably beating the average for all companies in the S&P 500 index. Hot stocks are characterized by fast growing revenue numbers.

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Is this the same for earnings numbers? Pretty much, yes. The next graph shows average EPS growth during the price rally. The average of all eight companies is a whopping 58%. Netflix has been the king of EPS growth, which averaged 146%. But, unlike with sales growth, not all of the companies have experienced this tremendous growth. TripAdvisor, and especially, Amazon have not been accumulating earnings for investors all that much. On the contrary, for Amazon EPS growth has been negative the last five years as the company decided to use every penny it earns to further enlarge its online empire.

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EPS represents the value from operations that are left for investors after all expenses are subtracted. There are other factors that measure profitability on a higher level. The most straightforward of these factors is probably (gross) operating margin. Operating margin gives a clean indication of what a company earns on its operations before cost factors kick in. The average operating margin of the stock market darlings are shown in the graph below. It's a mix bag. As a group the operating margin (15.1%) is somewhat higher than the operating margin of the S&P 500 index, but the numbers vary widely from company to company. TripAdvisor is a margin powerhouse while Tesla has thus far lost money on its operations. Amazon, LinkedIn and Netflix are other stocks that do not excel in operating margins.

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High Debt?

Until now the comparisons focused on equity related factors. But what about debt? Below are the average debt to equity ratios for the eight companies. Again, the differences between the companies are pronounced. Apple and LinkedIn have no debt on their balance sheet and the amount of debt on the balance sheets of Amazon en Google is low. However, as a group the debt to equity group is below 40%, which is significantly less than the debt to equity ratio for the S&P 500 index which averaged around 130% in recent years. Only Tesla, the one company that is active in a more capital intensive sector, has a higher debt to equity ratio than the S&P 500 index. But overall is seems justified to state that this group of hot stocks works with low levels of debt.

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No dividend!

Finally, I will try to get some grip on the ability of these eight companies to cash out any of their income to investors. First, do the companies earn any free cash flows? The next graph shows the average free cash flow yields. A quick look answers the question. Free cash flow yields of these hot stocks are low. Apple generates the highest free cash flow yield, but this is still shy of the yield of the S&P 500 index. Five out of the eight cash flow yields are below 3%, two of which are below zero.

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Low cash flow yields probably make it more difficult to pay out to investors. My last graph shows exactly this. Hot stocks don't pay any dividend. Apple started paying dividend again in 2012, but not before that. Google will pay a stock dividend this year, but normally does not pay out dividends. This compares to an average dividend yield of 2.1% for the S&P 500 Index. As you may have expected hot stocks make you happy by enormous stock price rises, not by steady cash flow income.

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Priceline.com

I want to add a few words on Priceline, by far the best performer of this group. This could be coincidence, but if you take all information into account is does stand out. Priceline's PE ratio is not that extreme. Its sales and EPS growth numbers are very strong as is its operating margin. Priceline has a low debt level and while the free cash flow yield is below average it is still decent. The only thing is that is does not pay a dividend. While never the number one when ranking on the different characteristics, Priceline scores well on all.

To sum up; when investing in stock market darlings make sure these companies keep realizing massive sales growth numbers. Strong growth in earnings per share also qualifies as a characteristic of hot stocks, unless you are Amazon. Amazon investors don't seem to worry about profits at all. And, finally, don't expect income out of your investment. Hot stocks don't pay dividends as there a busy with setting the next all-time high.

Source: What Makes Netflix And Tesla Hot Stocks?

Disclosure: I am long TSLA, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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