Netflix: How it’s a bubble but not a short by Andy M. Zaky @FortuneMagazine February 8, 2011, 4:57 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons Shares of the online movie retailer are up over 550% since the March 2009 lows. Sure, it’s overvalued, but is valuation a good reason to short the stock? Fund manager Whitney Tilson learned the hard way that one should never short a stock based on valuation concerns when we’re in the middle of one of biggest bull markets in modern history. Back in December, Tilson published a piece at Seeking Alpha explaining why his fund — T2 Partners — was short Netflix NFLX . He listed valuation and potential business-related headwinds as the core principles underlying his investment thesis. Tilson explained that, despite “losing a lot of money” betting against Netflix in 2010, he still believed it to be “an exceptional short idea” at $178.50. Since then, Netflix is up over 23.4% reaching fresh all-time highs of $220 a share last Friday. Yet, in an open letter sent to investors on February 1, Tilson appears to have reduced his short exposure (or is at least thinking about it). In the letter, he says his firm, T2 Partners, is re-evaluating its investment thesis with regards to “shorting good businesses that are growing rapidly, even when their valuations appear extreme.” This is obviously in reference to Netflix given that the stock was T2’s largest short position at the time. Netflix aside, Tilson has run a relatively successful fund. He declined to comment. This Tilson-Netflix short debacle illustrates a very key lesson to would be investors – a lesson that Warren Buffett has advocated on countless occasions — that valuation is a very poor timing tool. Valuation could be particularly useful in forecasting a stock’s future performance, but it can also spell disaster when used to make short or intermediate term investment decisions. The dot-com bubble and financial crisis are testament to this very principle. While you don’t want to be overly long in bear markets, you don’t want to get overly short in bull markets either. This is especially the case in bull markets spearheaded by a Federal Reserve chairman who dismisses asset inflation and speculative exuberance as a natural consequence arising out of heavy quantitative easing. It is clear that Netflix is overvalued and vastly approaching bubble territory. After all, the stock does trade at whopping 75 times last year’s earnings. And despite the rich valuation, the stock keeps ticking higher. Just last Friday, Netflix closed up yet another $8.58 (4%) on the day with absolutely no news to justify the move higher — a clear sign of froth. The company is expected to grow at a rate of 31.96% over the next five years. Yet, despite the lower long-term expected growth rate, the stock trades at 50.58 times next year’s expected earnings and 35.89 times 2012’s expected earnings, giving it at a high 1.5 price-to-earnings growth ratio (PEG). And while the stock is in fact expected to grow at a rate of 48.5% this year (according to consensus estimates) — which might justify the current forward multiple if it’s accurate — it would be irresponsible to assume that stocks should trade at a multiple based exclusively on next year’s earnings when the 5-year expected growth rate is far below the immediate-term growth rate. In fact, contrary to popular belief, stocks should trade at a balanced multiple somewhere between the 5-year and 2-year expected growth rate. Anything significantly above a 1 PEG-ratio suggests that a stock is probably — but not always — overvalued. Upside? What we have here with Netflix is a stock that is way ahead of itself. Everything positive is now completely built into the stock price from a fundamental perspective, which leaves exactly zero-margin for error and very little room to the upside without the stock turning into an outright bubble. Yet, just because Netflix is overvalued doesn’t automatically mean it is a good candidate for a short position. In fact, it’s a very dangerous proposition to short any stock with huge momentum in the midst of a very strong bull market like we have today. Instead, investors must formulate an investment strategy based partly on valuation, partly on momentum and partly on technical analysis. As long as the momentum remains strong to the upside, and as long as the uptrend remains in tact, the only way to play Netflix is on the long side of the tape. Once the momentum in the market shifts to a more negative environment, high-flyers like Netflix and Amazon AMZN are almost always the first to go. The selling is invariably the heaviest in stocks whose valuation makes very little sense. At the current price per share, Netflix is no longer a viable long-term investment based on its fundamentals. Yet, this doesn’t mean that the stock can’t go to $300 or even $400 a share. During the dot-com bubble, a lot of investors lost a tremendous amount of money prematurely shorting stocks based exclusively on valuation concerns. Thus, investors interested in playing Netflix from either the long or short side need to be nimble enough to not only recognize the shift in momentum when it comes, but they must also recognize when the long-term trend-line has been broken. Only when the trend shifts to the downside does Netflix become a good candidate for a short position. Until that time, watch from the sidelines or participate in the froth. But don’t short it. Also on Fortune.com: Apple still owns movie downloads Will Netflix stock go even higher? What the hell is going on with TV?