Microsoft vs. Netflix

NEW YORK (TheStreet) -- For the life of me, I can't understand why anyone would be willing to buy a stock like Netflix (NFLX), which is selling for over 37 times current earnings and a jaw-dropping 73 times forward (one-year) earnings.

Don't misunderstand me. I'm one of Netflix's satisfied customers as it's one of the only sources of virtually all great movies that were made in the past 60 years that a person could want to rent.

Even though the stock price has been cut by more than half from its $133.43 52-week high, it still seems expensive to me. Perhaps that's why CEO Reed Hastings doesn't appear to own any shares of his own company's stock.

In fact, none of the leading officers except Chief Products Officer Neil Hunt have much of a stake in the ownership of NFLX. Hunt, as of Jan. 1, owned 74,527 shares, which at today's stock price is valued at around $4,870,339.

In all fairness to Netflix, it does have a remarkable brand name and great loyalty among its faithful users. Having close to 25 million subscribers worldwide is nothing to sneeze at, and its nearest competitor, ( AMZN) through its "Amazon Prime" service, has yet to get its act completely together.

Yet, incessant rumors and suggestions persist that NFLX's business is experiencing a slowdown. Its dominance may also be encroached upon by other emerging competitors including Coinstar ( CSTR), which gives more reasons for shareholders to sweat with concern.

Amazon has tremendous resources to cash in on Netflix's vulnerability and with enough effort could duplicate what NFLX offers its subscribers. The competition could lower Netflix's revenue and earnings potential.

As of June 30, Netflix reported its year-over-year quarterly earnings had plunged 91%. Added to this is the worrisome reality that its operating margin is a pitiful 5.26% and its profit margin an even lower 2.87%.

The company does have an encouraging amount of levered free cash flow ($1.43 billion) and could use that to boost earnings potential through an acquisition or, even smarter, by offering "starving" shareholders a long-overdue dividend.

Here's a five-year chart that colorfully illustrates Netflix's plight. NFLX Chart NFLX data by YCharts

Netflix will report its next quarterly earnings results on Oct. 23 and shareholders will be listening carefully for the details and what kind of guidance going forward the company will offer.

Microsoft ( MSFT) is on the precipice of some significant earnings stimulants. With the advent of Windows 8 and the heralded Microsoft Tablet releases, MSFT and its earnings potential will be getting a large dose of publicity.

Shareholders hope it will mostly be positive and a boon to the stock's price which has taken a haircut of late. Let's take a look at a comparable five-year chart of Microsoft to see the story. MSFT Chart MSFT data by YCharts

Clearly, its diluted, year-over-year quarterly earnings could use a boost. But with the stock now selling at around $29 a share, it is trading with a forward (one-year) PE of only 8.79, making Microsoft appear more like a stodgy energy company than a technology innovator.

The trailing-12-month PE ratio is also a modest number (14.50), and this is a company that has a current dividend yield-to-price of a mouth-watering 3.2%. This member of the Dow Jones Industrial 30 has over $62 billion in total cash and $23.62 billion in levered free cash flow. The current dividend represents a sustainable payout ratio of only 38%.

By way of comparison, its operating margin stands at 38% and its profit margin at 23%. One measure of a stock's fair-market-value is its Price-to-Earnings-to-Growth (PEG) ratio. Microsoft's PEG ratio (five-year expected) is a low 1.12. Netflix's PEG ratio isn't currently available (one has to wonder why) while iconic Apple ( AAPL) is still the "low price leader" with a PEG ratio of only 0.60, suggesting it is still undervalued.

Back to MSFT versus NFLX: If you're an investor who wants to own shares of a company that has so many ways of making profits that the only way to remember them all is to go to its Web site's "products" page, MSFT is the clear winner.

If you want growth-at-a-reasonable price (GARP) and PE ratios that makes sense and you want to limit the amount of downside risk, then again MSFT is the comparative winner.

Unless Netflix has a secret success formula that it will be unveiling later this month, it is still in my opinion surprisingly overpriced. It is still the leader at what it does, but the competition is heating up on a number of fronts.

Microsoft will step into the earnings confessional on Oct. 18, so we won't have to wait long to hear how it has fared in the last quarter and what kind of guidance it'll offer. With Windows 8 and the Tablet about to be launched, Microsoft should have some good news that'll translate to an elevation in their share price. Accumulate carefully ahead of their earnings and upcoming guidance.

As of the time of publication the author has a position in MSFT.

Jim Cramer and Stephanie Link actively manage a real money portfolio for his charitable trust- enjoy advance notice of every trade, full access to the portfolio, and deep coverage of the latest economic events and market movements.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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