Why Netflix Investors Are At The Edge Of Their Seat

Netflix investors might’ve been planning on a chill evening on Wednesday, but the company’s star-studded third-quarter earnings gave them a reason for an after-party.

The big rally-sparking surprise was the 8.8 million net new subscribers the streamer pulled in. That’s a couple of million more than most analysts had expected and around 11% more than the same quarter last year. It’s also the fastest growth in some time. And it happened even while Netflix has been pulling back on content costs: the firm produced almost $2 billion in free cash flow in the quarter, again way more than anyone had predicted.

All told, then, it seems Netflix’s efforts to profitably increase subscribers, by clamping down on password-sharing and introducing a lower-priced advertising-loaded plan (subscribers to that grew 70%) are paying off, at least for now. In fact, the company felt confident enough about its new belt-tightening and cash-producing prowess to buy back $2.3 billion of its own shares and to boost its future buyback plans by a massive $10 billion. After all, it’s got reason to rub its hands together when looking at its finances: there’s a price increase around the corner for its ad-free plans and some buzz-worthy highlights on its lineup for the current quarter, including the record-smashing David Beckham documentary.

Zooming out: Grab some popcorn.

For investors, there may be something else to get excited about. At the end of the day, stock prices go up for two reasons: profit growth or valuation expansion. Thing is, those two forces rarely coincide. That’s because the valuation expansion tends to happen first. Think about the price-to-earnings (P/E) ratio: it can expand and drive a higher stock price even if profit (E) isn’t going anywhere. When companies start to become more profitable though, the P/E tends to stop rising or even falls, but the stock price can still rise as the “E” starts to fly. Now, on the basis of Wednesday’s earnings, Netflix’s profit (or E) looks set to accelerate. And that alone should lift the stock price even if the P/E stays steady. But, because the stock’s P/E ratio is sitting at 25 – about as low as it’s ever been but for a brief period last year – there’s a chance that it could rise too. So if the P/E goes up, and the E (profit) starts to motor, then Netflix’s stock price could get a double boost.