November 3, 2011

Priced to perfection

With both Netflix and OpenTable stock prices down around 75 % since the beginning of the year, one could expect both companies to be doing badly. When both are actually doing quite ok operationally (even if the Qwikster detour wasn't Netflix's best moment).

The main reason behind the companies' lower stock prices is that both stocks were priced to perfection with magical valuations of around 100 times earnings. And when the companies didn't turn out to be perfect, the magical valuations vanished.

When shares are priced to perfection, the margin of error becomes really thin. Results not meeting expectations? Valuations can go down 20-30 % in no-time. In addition, public market investors are  not getting the same downside protection as late-stage private market investors get. Rather the opposite as free floats are small and insiders control the companies with supervoting shares.

It's worth remembering that Microsoft went public in 1985 with revenues of $172.5 million and 34 % pre-tax profit margins and ended up with a valuation shy of 800 million dollars on its first day of trading.

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