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Don’t Make This Expensive Mistake

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Valuation can be very important when it comes to making investing decisions, be it on the long side or the short side. However, valuation ratios should always be analyzed in the context of the company´s overall business strategy and growth potential. Shorting disruptive growth companies only because they seem overvalued can be a very expensive mistake.

The value of uniqueness
Tesla Motors (NASDAQ: TSLA) has been a textbook example of the kinds of risks investors face when taking short positions in innovative growth companies with big long-term potential. Short sellers have been betting strongly against the electric car manufacturer over the last few quarters and, even after a whopping rise of more than 360% in the last year, the company still has a short interest ratio above 25% of float.

Tesla has achieved remarkable milestones lately, the Model S is an amazing success, and Tesla can´t build its cars fast enough meet demand. Even if carbon tax credits are a big factor behind the company´s profitability, the fact is that Tesla is not losing money anymore, and that says a lot about its long-term viability and growth possibilities.

None of these means that the company is fairly valued, of course. When comparing valuation ratios for Tesla versus other car manufacturers, the difference can be astonishing. Tesla trades at a forward P/E ratio above 100 times next year average earnings estimate, while most traditional automakers are in the area of 10.

Still, who is to say that Tesla is comparable to companies like Ford or General Motors? Tesla is the only pure play on electric vehicles, if the future of the automobile industry is going to be electrically powered, then the company is a unique opportunity for investors.

Besides, Tesla has Elon Musk on board, the company´s founder and CEO is one of the most successful and visionary leaders in the world, he has already made some extraordinary inroads in industries like electronic payments, solar energy, and space travel. For all we know, Musk may be on his way to dramatically changing the automotive industry, and it’s really hard to put a fair price on an investment opportunity like this one.

Don´t get me wrong, I´m not saying that Tesla is reasonably priced, only that there is a lot of uncertainty regarding what should be a fair valuation for such a unique business. It would be very hard to justify a long position in the company based on valuation multiples, but comparing Tesla against other auto companies is too short-sighted.

Companies like Tesla are all about the long-term; current sales or earnings don´t even begin to describe the possibilities. Taking a short position in the company because it looks overvalued based on traditional valuation metrics means forgetting that this is not a typical company by any means.

Long-term growth vs. short-term profits
Netflix (NASDAQ: NFLX) used to be one of the most popular bearish bets among short sellers not so long ago. A steep rise of more than 290% in the last twelve months has sent many bears running for cover, but the company still has a considerable short interest near 12%.

Looking at valuation ratios, the company looks very expensive: Netflix trades at an astonishing P/E above 320 times earnings. However, the P/E ratio may not be the best tool to analyze Netflix.

The company puts long-term growth opportunities above short-term profit margins, and original content is a big part of that strategy. Netflix doesn't disclose production costs, but industry analysts estimate that series like House of Cards and Orange Is the New Black may cost something in the area of $4 million or $5 million per episode.

Charging $7.99 per month, it would be almost impossible to generate enough new subscribers with each original production to cover those costs in the short term, but that's not what Netflix is concerned about.

The company wants to build a large and valuable library of content, compelling enough to make the modest membership fee look like bargain in relationship with the value of the service it´s offering. As the company continues growing its collection for the same price, the proposition gets increasingly attractive over time.

Netflix is not trying to make a lot of money now; the company is focused on gaining subscribers and providing a convincing proposition to its customers. Online streaming is a business with enormous potential for growth in the long term, and Netflix wants to make sure it secures a leading position to capitalize on that opportunity in the future.

Bottom line
When it comes to disruptive growth companies like Tesla and Netflix, investors need to consider that current earnings figures don´t provide enough information to make a solid investment decision. Value investors may prefer to stay away from these kinds of companies, and that’s a completely reasonable decision.

On the other hand, taking a short position in these kinds of businesses based on valuation ratios has been a losing proposition in the past, and it also sounds like a dangerous idea on a forward looking basis.

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Andrés Cardenal owns shares of Netflix. The Motley Fool recommends Netflix and Tesla Motors . The Motley Fool owns shares of Netflix and Tesla Motors . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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