This should be a short piece, but I wanted to use a few examples to describe the assumptions inherent in stock prices and why investors need to think through stock valuations. Given that price is a major factor in predicting future returns, investors should of course be unwilling to pay anything greater than the present value of all future free cash flows, discounted at an appropriate rate for any investment. If the investor pays anything more than that, they will likely receive returns lower than their discount rate/required return.

I think at present there are certain instances in which investors are a bit euphoric and may not be critically examining the assumptions built into the prices of the companies they own. I'd like to use Netflix as an example here, because I believe it is the most egregious offender on this front.

Netflix currently has a market capitalization of around $75 billion, and had $360 million of net profits in the past 12 months, for a P/E of 208. For the non-financial types, this would mean at Netflix's current level of earnings, it would take an investor 208 years to re-coup their investment before making any profits. Of course, the assumption is that massive growth will lead to the earnings eventually becoming high enough to justify this valuation.

I've discussed Netflix on certain online forums and would rather not get into explaining my opinion regarding the company's potential for competitive advantage in the future. I won't even discuss the number of subscribers or revenues it will need to attain, as that would require forecasting profit margins and we could all disagree on what Netflix's mature-level profit margins may be. This analysis will be as simple as it gets- we will look at what the market capitalization must be 10 years from now in order for Netflix investors to receive a 10% annual return, and what earnings must be in that case to deliver a reasonable mature P/E.

With no share buybacks, to get an annual return of 10%, Netflix's market cap will also have to grow 10% a year. The table below (all $ in billions) shows this. In the row 'market cap', I took NFLX's current market cap and made it compound at a 10% rate over the next 10 years. I then calculated what the earnings must be to deliver a P/E ratio of either 20 or 30 in the two columns below. With NFLX's market cap growing at 10% a year, to get a P/E of 20 in 2027, earnings would have to be $9 billion and to get a P/E of 30, earnings would have to be $6 billion.

To get to $9 billion in earnings by 2027, Netflix's current earnings would have to grow by about 39% a year. To get to $6 billion in earnings by 2027, Netflix's current earnings would have to grow by about 34% a year. Over the past 10 years, Netflix's revenues have grown by 24% a year, and its earnings have grown by 14% a year. To get to either $9 or $6 billion in earnings by 2027, Netflix would have to somehow grow earnings over the next 10 years about 50% faster than it grew revenues over the past 10 years. It would also have to almost **triple** its earnings growth rate of the past 10 years. Does this seem plausible?

In the row titled 'net profit', I took Netflix's current earnings and had them grow at a 25% annual rate over the next 10 years- so if Netflix somehow grew earnings over the next 10 years at the rate it grew revenues over the last 10, it would have about $2.7 billion in earnings by 2027. For the market cap to have grown at a 10% rate through 2027, with those earnings, the P/E would be 66, so it would take an investor 66 years of current earnings to pay back the price of the stock. If we go even further and assume it keeps growing earnings at 25% a year after 2027, and the investor wants a 10% return, we would finally reach a P/E of 20 in 2037, with $25 billion of earnings and a market cap of $459 billion. So earnings growth would have to nearly double and remain that high over the next 20 years and only then would investors receive a 10% annual return. Clearly this is not going to work to bring investors a 10% annual return, even in very the long-run.

The numbers required for an annual return of 5% aren't promising either. NFLX would need $4 or $6bn of earnings to have a 2027 P/E of 30 or 20, respectively. Even to get those $4bn of 2027 earnings would require 27% annual growth in earnings. Again, I don't see how the company could grow earnings at a higher rate than its revenue growth rate over the past 10 years.

The same exercise could be done with Amazon. AMZN currently has a market cap of $469bn, with 2016 earnings of $2bn for a P/E of 246. To get a 10% return over the next 10 years, it would have to have a market cap of $1.2 Trillion in 2027. At a P/E of 30, it would need around $40bn of annual earnings. Unlike Netflix, I actually believe Amazon has a chance to justify its valuation in the long run but it cannot have free cash flows permanently higher than operating earnings as it currently does- it will eventually have to generate earnings high enough to justify its valuation. Like every other company, when it matures, its free cash flows will be lower than its operating earnings. I do not believe a 10% return for Amazon shareholders is in the cards for reasons similar to that of Netflix- the current valuation is simply too high.

Investors willing to purchase rapidly growing companies at earnings multiples north of 200 need to seriously consider their future potential returns from such investments. Even with perfect business execution and total global market domination, I believe investors in both Amazon and Netflix in particular will be lucky to generate mid-single digit returns over the next decade. Of course, the future is difficult to predict and industry conditions can change quite rapidly. Amazon seems to be well positioned for the long-run, but there will no doubt be imitators and competitors for both of them, and Netflix's position is not as impenetrable as Amazon's. Again, to generate significant returns the investor much receive value relative to the purchase price, no matter how high the company's growth or returns on capital. I do not see any value here.