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This is a Guest Post by AK of Fallible
AK has been an analyst at long/short equity investment firms, global macro funds, and corporate economics departments. He co-founded Macro Ops and is the host of Fallible.

Recently Netflix (NFLX) surpassed Disney (DIS) in terms of market cap, making it a more valuable company in the eyes of the market. Many investors couldn’t believe it. Today we’ll use this example to explain the correct way to look at valuations so that biases don’t keep you from jumping on great opportunities like Netflix!

The first thing to realize is that all valuations are theoretical. They’re made by people, and people can value anything at any value they want. Why were Pokemon cards so valuable back in the day? They are nothing more than small pieces of paper. Yet certain cards were selling for hundreds of dollars. That’s because valuations are subjective. It’s completely based on opinions.

Expectations have a lot to do with valuation as well. If investors think Netflix will continue to dominate media, they will value it higher. If investors think Disney has been to slow to switch to streaming, they’ll value it lower.

Valuations get funny at high levels as well. Netflix has a very high P/E ratio of 210. At that point, what’s the real difference between 210 and 250? It’s all just extrapolation into the future. And the future is impossible to predict. The next 5 years will look completely different from the last 5 years. So who is to say the P/E ratio can’t be 300? It’s just playing with numbers at that point.

This is also the reason that high flyers like Netflix tend to crash so hard. With valuations being as high as they are, there tends to be a lot of air added in. So for the same reasons that Netflix may have a P/E of 300, couldn’t it easily have a P/E of 200? Prices are fast to correct when this is the case.

Make sure to watch the video above for more! And as always, stay Fallible out there!