A reader named Marc who has become a friend over the past year corresponds with me from time to time. This week he wrote me about Netflix (NFLX) as an excellent very recent example of a major point of emphasis in my book, “Choose Stocks Wisely.”

In the case of NFLX, the book value (per Yahoo Finance) is just under $27 a share. If you subtract out intangible assets, as I do when attempting to determine a low stock price using my Adjusted Floor Price Scorecard, NFLX’s book value (equity) per share is actually negative. Yet the stock closed at over $448 per share on Wednesday of this week after reaching over $489 per share back in September.

On Wednesday afternoon, after the market closed, NFLX delivered an earnings report/outlook that was less than what investors wanted. On Thursday, the stock traded as low as $331 per share (a drop of well over $100 per share and a market cap decrease of over 6 billion dollars). It closed today (Friday) at $357.09. How does one even speculate on the risk (downside) of a stock (and NFLX is not nearly the only one) with so little equity relative to its stock price when investors are soured by an earnings report?

I used the following simple illustration this past week in a conversation. If you have a savings account that holds $10 and you want to sell it to me for $8, I’m not really that concerned about the interest rate the account is expected to earn. I’m buying $10 for $8; sure, I’ll take that deal. The interest just makes the deal all the more attractive. On the other hand, if you say that you have an account with $1 in it and want to sell it to me for $8, well it would have to have an astronomical rate of interest expected for me to become interested. So, which would you feel safer buying: an account with an amount in it virtually sufficient to support your purchase price AND with an expectation for improvement — or an account with little in it but lofty expectations for seeing the account improve?  The difference is little risk vs. a lot of risk.

Think of the balance in the savings account illustration as the amount of quality tangible equity on a company’s balance sheet and think of interest on the savings account as the earnings expected by a company.  Now overlay my savings account illustration on the NFLX situation described above.

For me, I’ll continue to adhere closely to the balance sheet to determine how much equity I’m going to get for my dollar and the quality of that equity. Now, if I can buy that solid equity position, my backside is protected substantially and the company growth expectation I’m ALSO looking for with my investment choices becomes all the more appealing.

My home state of Mississippi is looking pretty good this week in the realm of football; my school, MSU is ranked no. 1 and that other school :), the University of Mississippi (Ole Miss) is ranked no. 3.

Have a nice weekend everyone and may God bless.