The word "risk" means different things to different investors. Wall Street tends to think of it in the context of volatility, where greater volatility equals greater risk -- even if the stocks trend higher as a result. We look at it differently, however. Fool co-founder David Gardner defines risk as "the chance that your investment outcome will be a substantial loss of capital."
Understanding this type of risk is a very important skill for investors, especially for those seeking the kinds of high-growth, high-return stocks David features in his Motley Fool Rule Breakers service. With that in mind, David and his team recently unveiled a new tool that you can use to assess the riskiness of any of your stocks. It's meant to be used to look at any stock, not just potential high growers.
The process is simple: Run your company through the 25 questions below, tally up the number of "no" answers, and see where it falls on the scale. I'll use Netflix
Yesterday, I put Netflix through its SWOT paces, looking at the company's strengths, weaknesses, opportunities, and threats. Today, we'll see how it stacks up on this risk rating metric.
THE COMPANY (0/5 = "no")
1. Profitable: Is the company profitable over both the past quarter and past 12 months?
Yes.
2. Cash Flow: Is the company cash flow-positive over both the past quarter and past 12 months?
Yes. Even if you count acquisition of the movie library as a capital expenditure.
3. Brand: Does the company's business rely on recognizable branding truly valued by its buyer base?
Yes. Netflix needs to become the go-to brand for movie viewing at home or on the go.
4. Diversified: Has the company diversified its buyer base such that no single customer accounts for more than 20% of revenue?
Yes. With 17 million subscribers, I'd say so.
5. Raving Fans: Does the company receive, on the whole, positive word of mouth from its customers?
Yes. According to the company, more than 70% of subscribers have had the service recommended to them by an existing subscriber.
FINANCIALS (0/5 = "no")
6. Growth: Is the company growing its sales by between 10% and 40% annually over the previous three years?
Yes. 18% annually over the last three years. That trails competitor Coinstar
7. Independence: Can the company operate its business over the next three years without relying on external funding?
Yes. Even though it issued debt recently, with its positive cash flow and $266 million in cash, it could rely on internal sources alone.
8. Disclosure: Does the company report to a high standard of disclosure, consistent with SEC guidelines in the U.S.?
Yes.
9. Transparency: Would an intermediate-level investor find the company's financial statements and management ownership disclosures relatively easy to sift through and understand?
Yes. The discussion is clear and the footnotes are not too dense.
10. Well-Managed: Over the most recent fiscal year, did the company report a return on equity of 15% or higher?
Yes. At 42.4%, it handily beats this metric. However, that comes with the caveat that shareholder equity has been declining as management repurchases shares and charges that against additional paid-in-capital and retained earnings, the two largest components of equity.
THE COMPETITION (3/3 = "no")
11. Underdog: Is the company free of any direct competitors possessing substantially (2x+) greater financial resources?
No. Disney
12. Goliath: Is the company free from disruptive upstarts visibly challenging its business model?
No. It doesn't take a lot to get into streaming.
13. Moat: Would potential new competitors face high economic, technological, or regulatory barriers to entry?
No. For streaming, no. For DVD-by-mail, it would take several years to build out the library and mailing system, not to mention the recommendation engine.
THE STOCK (1/3 = "no")
14. Market Cap: Does the stock have a market cap of greater than $500 million?
Yes. It's currently at $5.7 billion.
15. Beta: Is this stock's beta rating over the past 12 months less than 1.3?
Yes.
16. P/E Ratio: Does the stock have a positive price-to-earnings multiple that is below 30?
No. Its trailing P/E ratio is a hair under 50, which means a fair amount of growth is priced into the stock.
PEOPLE (1/2 = "no")
17. Founder: Do any of the founders or founding family still have at least a 5% stake in the company?
No. Founder and CEO Reed Hastings owns about 2.8% of the outstanding shares.
18. Experience: Do the top three officers have more than 15 years of combined leadership at the company?
Yes. Hastings has been there since 1998; CFO Barry McCarthy has been in that position since 1999. Other senior management has been there for at least eight years each.
SERVICE-SPECIFIC (1/2 = "no") ... here, Stock Advisor
19. Stock Advisor: Does this company meet a majority of David's or Tom's investing rules?
No. This is a pick from both Tom and David. The two of them collectively have six criteria, but I only see Netflix meeting three of them, maybe two, at this time. This company has an edge with its by-mail service and recommendation engine, not to mention the word-of-mouth advertising its customers give it. If it can fight off threats to its streaming business, it will certainly take advantage of the move toward streaming. The business model is proven and efficient, but the financials have gotten weaker as Netflix decreases shareholder equity and takes on debt to repurchase shares.
20. Is management looking out for the interests of all stakeholders -- customers, employees, shareholders?
Yes.
FOOLISHNESS (4/5 = "no")
21. Immaculate?: Is this company certain to be fault-free and fraud-free in all its corporate statements and deeds?
No. This will be a "no" for almost any company.
22. You: Do I want to know more about this company; am I willing to dig deeper, learn more, and ask questions on the boards to actively try to understand this company?
Yes.
23. Custom question No. 1: Ask and answer the most insightful question you can come up with when assessing this specific company's risk.
Can Netflix stay ahead of the competition in streaming?
No. I have to answer this way, because the issue is still in doubt. The company's content licenses are not exclusive to Netflix, and until Netflix becomes the dominant deliverer of streaming content, the providers have no incentive to give Netflix exclusivity. This helps competitors and makes Netflix a price-taker instead of a price-giver where content is concerned.
24. Custom question No. 2:
Will Netflix be able to successfully export its model internationally?
No. Again, I have to answer this way because it's untried. The U.S. has a very efficient mail system, compared to the rest of the world, which would hurt any attempt to repeat the DVD-by-mail model elsewhere. A streaming-only model is untested, and even though many foreigners love watching American movies and television, do they love it enough to sign up by the millions? Can Netflix license locally produced content? All these unknowns must be answered in the positive for Netflix to successfully grow internationally.
25. Bulletproof?: Can you be certain that this company is invulnerable to external world or macroeconomic events, such that you're sure you can get all your capital back?
No.
I count 10 "no" responses, giving this stock moderate risk on the Risk Ratings Scale:
Risk Ratings Scale
High (20-25 points)
Moderately High (15-19 points)
Moderate (10-14 points)
Moderately Low (5-9 points)
Low (0-4 points)
Netflix has a lot of opportunity, but it faces some serious threats in the near- to mid-term future. It's beaten back such risks in the past -- Wal-Mart Stores and Blockbuster come immediately to mind -- but it's playing in a different sandbox this time. We'll see how that works out.
With a checklist like the one above, you'll think about your company from several different angles. Do it for each of your companies. I promise you'll come away with a greater understanding of the businesses and their future prospects!
