AAII Investor Update: High Valuations Increase Downside Risk

Posted on October 28, 2011 | Investor Update

If there was any single financial concept I think investors should remember, it is the one above. The more investors bid up a stock’s valuation, the less room the company has for error. When a highly valued company does disappoint, the drop in a stock’s price can be significant. Netflix (NFLX) and Amazon.com (AMZN) are two examples.

Netflix has been a poster child of how poor management decisions can simultaneously anger both customers and shareholders. As many of you know, the company has been stumbling since July when it announced separate price plans for DVD rentals and online video streaming. (The stock’s price-earning ratio at that time was a pricey 85.) In September, CEO Reed Hastings threw gasoline on the fire by saying DVD rentals would be split into a separate business named “Qwikster.”

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