Netflix by My Numbers

OK, it's time to put my cards on the table. You can call me a Netflix (Nasdaq: NFLX  ) fanboy if you like, because I really am a fan of the service, of CEO Reed Hastings, and of the stock. Why? Because I don't know of a better value proposition for entertainment in the digital age, because Hastings runs his company like an engineer with a vision, and because the stock still has a long way to run.

Relative valuation
Let's start by comparing Netflix to some other new-media companies. This technique, known as relative valuation, compares and contrasts a stock to other companies in the same industry, with a similar business model, or cut from the same cloth in other ways. It's simplistic and a dangerous way to run a portfolio, but a useful starting point for discussion -- and not far from how a lot of big businesses go about figuring out paycheck and bonus sizes for their executives.

First of all, a trailing price-to-earnings ratio of 62 and a forward P/E of about 41 sure make Netflix look expensive at first glance. But when put in context with a few new-media peers, the picture changes in a hurry:

Company

Trailing P/E

Forward P/E

Price to Earnings to Growth (PEG)

Netflix 62.7 41.5 2.1
Amazon.com (Nasdaq: AMZN  ) 64.8 44.1 2.4
Sirius XM Radio (Nasdaq: SIRI  ) N/A 70 N/A
Coinstar (Nasdaq: CSTR  ) 21.7 15.5 0.8
Apple (Nasdaq: AAPL  ) 22.7 16.9 1.0

Source: Yahoo! Finance.

In this light, Netflix stands up pretty nicely to digital media rival Amazon. Sirius, which also sells entertainment in a new format attached to a subscription model, isn't profitable today but looks even more expensive than Netflix in the forward-looking mode. Both of these companies have hordes of supporters and happy investors; that's no guarantee of Netflix being affordable, but it's a sign of market acceptance for businesses in the same general boat as Netflix.

Coinstar's rental boxes inspire less of a feeding frenzy among investors. In my opinion, the company is investing a lot of capital into something that will be remembered as a stopgap measure in movie history, and you can't convince me that Redbox machines have a future until they're paired with a reasonable digital strategy.

Then we have Apple, also looking relatively cheap despite its gargantuan market cap. That's because you simply can't support enormous price-to-earnings ratios for a company this big: Remember that the PEG calculation wants to put a growth value on P/E ratios, and that the law of large numbers says it's tough to grow fast when you're big. That's not where Netflix stands at this point in time.

Lead by example, Steve
By my calculations, Netflix should just about quadruple its earnings when it flips the growth switch into the income-generating mode. Let's say that happens in five years. At its current rate of subscriber growth, Netflix will have something like 40 million subscribers or a 22% annual growth rate. Assuming revenue grows 15% a year, cost of goods sold grows 10% a year, and operating expenses keep up with revenue, the firm should produce roughly $570 million in net income in five years. Assign a P/E ratio of about 20 times the earnings trickling out of that income statement and you get a stock price of about $217 in five years.

This model assumes that Netflix doesn't expand its business model significantly but only refines the domestic sales it has going today. In my eyes, it's a worst-case scenario, and you still end up protecting your assets at the very least.

Switch to the growth assumptions of your average analyst (26%), and my financial model shows $1.2 billion in net income by 2015, or about nine times the current tally. A more reasonable P/E value around 20 times trailing income should then give you a share price just above $460 per share in five years and a $24 billion market cap. Netflix would then be an entertainment powerhouse fully in class with Time Warner (NYSE: TWX  ) or News Corp. (Nasdaq: NWSA  ) . The digital changing of the guard will be under way by then, and Netflix should lead the charge against the old media powers. This, in my opinion, is where Netflix is going over the next five years, and I still think I'm being conservative.

What it all boils down to
For a sense of scale, consider that about 13% of all American households are Netflix subscribers today but household penetration in the San Francisco area is twice as high and still growing. Let's say that the domestic subscriber count could triple in five years to something like 45 million -- there's that 40 million customer count again! Then add in the fact that Hastings sees 80% of his business coming from abroad when all is said and done. That won't take five years, but there's a serious chunk of upside to my calculation with even a little bit of international growth.

So there you have my numbers and why I believe in them. At worst, Netflix is priced for perfection. At best, the stock could double and then triple again in the next five years without breaking a sweat. The truth probably lies somewhere in between, and that makes for a great investment.

Has Anders finally gone off the deep end? Discuss his assumptions and motivations in the comments below. And don't forget to add Netflix to your watchlist so you can see how the story develops.

Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor picks. The Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.


Read/Post Comments (16) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 18, 2010, at 2:51 PM, BioBat wrote:

    We've already seen the big boost from 360 owners in 2009 and then subsequently by PS3 and Wii owners in Q1 and Q2 of 2010. A million new subs is doable, but 1.5-2 million like many analysts are expecting seems like they're asking too much and we've seen some pretty significant selling on good, but not "out of this world, are you kidding me, how'd they do that?" kind of news. We've seen Netflix consistently outperform but with such a microscope on them now, they've got essentially not margin of error anytime in the next few years to justify the premium stock price. That might be a bit too much to ask for. So with that, I'm happy to take my profits after seeing my position triple in under a year. Too much, too fast.

    Worldwide expansion is key to growth and I think it can happen but I think a lot of that is already factored into the stock price and Netflix faces competition in the EU with Love Film before even getting its foot in the door. We'll see if they become the worldwide leader or not but Netlix now has a target on their back that they didn't have last year at this time.

  • Report this Comment On October 18, 2010, at 2:58 PM, joshpritchard wrote:

    I am going to add it to my portfolio based on your recommendations. I really hope you're right!

  • Report this Comment On October 18, 2010, at 5:07 PM, BioBat wrote:

    I should note that I will be happy to buy back in on price dips as well because Netflix is going to see them. Heck, Apple just delivered out of this world earnings but is down 6% after hours because analysts fret that the iPad didn't sell as well as they hoped. Investors are fickle and reactionary these days.

    Anything short of perfect Q3 results on Thursday for Netflix (at least 1.7 million subscribers added, $.78 per share or higher, and $550m+ in revenue). I think they will probably hit or come within their guidance set forth at the end of Q2 for earnings per share and revenue but I don't think they'll hit the subscriber target and investors that don't know how great a company is will see it as a signal that growth has slowed. Selling will follow (as it did after Q2) and Friday through next week will provide new entry points for investors.

  • Report this Comment On October 18, 2010, at 8:27 PM, CFischer wrote:

    Ah, numbers!

    > By my calculations, Netflix should just about quadruple its earnings when it flips the growth switch into the income-generating mode. <

    1) Can you share your calculations with us? Exactly which expenses (other than some direct marketing expenses) can they drop when they "flip the switch?

    2) 40 million subscribers in 5 years represents 4 out of 7 US households that have broadband. Do you really think this is realistic?

    I agree with Biobat above. I think this stock is priced to perfection, I think there is a very large chance that Q3 earnings are a disappointment and the stock drops 25% immediately. I think the chance of them beating + raising guidance is zero. If I'm wrong, I'll tip my hat my hat to you in two days. But I'm expecting NFLX to miss of Revenues and Subscribers.. maybe badly on the Subscribers.

  • Report this Comment On October 18, 2010, at 8:28 PM, penchy1 wrote:

    How about Blockbuster migrations to NFLX? Or is that inconsequential?

  • Report this Comment On October 18, 2010, at 8:35 PM, desirevideo wrote:

    I wanted to buy NFLX and CSTR stock years ago but at the time I noticed most college age students downloaded and streamed everything and I figured that it would reach a critical mass fairly quickly...unfortunately for me I was wrong and although piracy has grown...it has still not completely hit all of the customer base...Still, with no apparent internet regulation on the horizon...how can you remain so bullish on this stock when faster internet speeds will continue to erode the use of physical media and legitimate streaming sites...Do you know whether there is any plan in the works to thwart the rampant piracy? ...If there was then I'd say NFLX would be a definite buy...but since there isn't I can only see pain for the company in the future

  • Report this Comment On October 19, 2010, at 12:24 AM, foolishkids wrote:

    Netflix is a "buy" both short and long term. There are plenty of un tapped opportunities for the company to grow its revenues and profits. It is already a household name. I know many, including myself, that have signed up for Netflix service in the last couple of months. Their customer base will be increasing at much faster rate in the months ahead as people realize that watching streaming videos is now a reality and all it takes is to purchase an internet enabled box such as game consoles, blue-ray DVD players, or laptop computers. My daughter uses ipod touch to view netflix movies and we enjoy HD movies streamed to our 62 inch TV. The picture quality is perfect. As a family, we watch perhaps 3 movies per week and we enjoy Netflix recommendations based on our previous viewings and movie ratings. Eventhough currently netflix revenue does not come from advertising (that is my understanding anyway), they may decide to go that route in future for incremental revenue. At $8B market cap netflix is cheap. It can easily be twice or more. I can even imagine Netflix selling movies and other type of digital media to its customer base in future if they decide to explore those opportunities. The possibilities are unlimited and hence the stock is in no way overpriced.

  • Report this Comment On October 19, 2010, at 7:59 AM, TMFZahrim wrote:

    @desirevideo, I would posit that the best weapon against piracy is to offer a better service on legal terms. Let's say that Netflix one day (not tomorrow, obviously) gets full digital streaming licenses from all the major studios, creating a catalog that can compete with the pirates in terms of selection. Would you then prefer to a) Stream movies through Netflix for a reasonable monthly fee, from a well-organized and categorized catalog with no fear of unexpected hassles, or b) stick with free pirated content, dodging malware, viruses, and phishing attacks along the way to perhaps getting sued to within an inch of your life by angry MPAA lawyers -- assuming you can even find the films you wanted today and was willing to sit through a lengthy download before watching anything?

    Beat the pirates with their own stick until the problem goes away. That's what Netflix is doing today, and is working hard to get better at. At which to get better. Oh dear.

    Anders

  • Report this Comment On October 19, 2010, at 12:37 PM, desirevideo wrote:

    @Anders

    I'm not sure how terms were negotiated but I'm sure when Reed approached the studios he said something like you are currently making x million off of these catalog titles...we'll give you x +10% if you allow us to stream them...The studios were of course happy for this immediate gratification, not realizing that they put the equivalent of a huge video store in everyone's house, cannibalizing a large percentage of any future dvd sales...My point is that future negotiations won't be so rosy and the costs to have a full streaming catalog won't be so easy...Everything for 9.00 a month sounds pretty good but I'm sure after all content is renegotiated it'd be more like a current cable or dsl bill...30.00 to 40.00 and even that seems low...Meanwhile piracy becomes higher and higher quality and safer and easier...If one is worried about phishing attacks or malware they could just have one dedicated old computer that they used expressly for this purpose that had no information on it...the RIAA's lawsuits are too infrequent to have any real deterrent effect.

    What I would do to save the economy although no politician will have the balls to do it...is randomly issue 30 dollar infraction tickets to ip addresses that illegally download or stream and in one month people would either start going to legitimate sites or better yet go outside and spend money in the physical world...If they enacted this type of policy then Netflix would be a winner...As long as we all stick our collective heads in the sand and give our content away for free...the economy will continue to deteriorate and people will pay less and less in the future.

  • Report this Comment On October 19, 2010, at 6:05 PM, joshpritchard wrote:

    @Anders -- I allocated 15% of my allocation to a long position in NFLX on your recommendation. I really hope earnings are good(!)

  • Report this Comment On October 19, 2010, at 6:39 PM, CFischer wrote:

    josh- Hope it's not money you really needed. Wrong or right, this stock is highly speculative.

  • Report this Comment On October 21, 2010, at 1:25 PM, dachuyn wrote:

    I love this guy (the author). You should sell your home and put the money in NFLX. Home price goes down; NFLX goes up. No brainer!

  • Report this Comment On October 22, 2010, at 7:11 AM, nflx2bbi wrote:

    @Anders, you sounded like my landlord twenty years ago "you will be in Manhattan in 12 minutes". In a perfect world, .... Love NFLX but not to the level as you hyped.

  • Report this Comment On October 24, 2010, at 1:54 PM, naandrews wrote:

    Anders,

    Interesting take on Netflix, my question for you is, why will Netflix ever be able to "flip the growth switch": aren't they always going to have to be plowing everything back into the business, to continue to gain rights to all the content, and to continue to increase subscribers? --Neil

  • Report this Comment On January 04, 2011, at 3:06 PM, darrelll13 wrote:

    I also like NFLX as both a stock and service. I see them making excellent margin and I expect the studios to decide they unvalued their contracts. I expect the next contract to be much more studio sided and NFLX margins to be pinched. My fear is that it is a long term investment that is very risky because you'll loose big when the new contracts are announced. I have a small position, but won't expand that until the bad news starts piling on and we get a big pull back. I also think 40 M is highly dependent on expansion of households with DSL which I'm not seeing. What do you think the down side is if their margin is halved by the studios?

  • Report this Comment On March 30, 2011, at 8:48 PM, thinktwicemore wrote:

    Your analysis is nearly perfect. It lacks the "internal behavior" of Netflix: Is Management doing nothing while all this is going on? NO! There are some assumptions that very "national oriented" analysts and investors make when they analyze a Company rather than Global Strategic Marketing and/or Global Strategic Management.

    The world is bigger than just Spain, Germany, the UK, BRIC, the USA, or Canada. I have lived in the USA for over 30 years and another 30 in many other countries around the world. Let me state outright that people living in the US don't know how cheap things cost there. The NETFLIX subscription and a DVD per month costs $9USD and that amounts to €7/month in Europe with many countries full of fluent English Speakers and Movie Lovers (meaning that they would love to watch "old" but great movies as those Netflix has and that the NY Times considers the Best 1,000 Movies of all times. Samsung is video streaming successfully in Spain and in the UK that I know of through Samsungmovies.es and Samsungmovies.uk. Even Samsung itself has been beaten badly because most analyst in the West don't understand the Korean language and that is where the top analysis are and not in English: They are coming out with 3D TVs WITHOUT Glasses (check trustreviewes.co.uk) Netflix is already running very successfully and there are more companies out there than Apple, Hollywood Studios, Google, FB, Amazon, or Warner that would love to hook-up with Netflix. Yes, Netflix has to overcome intellectual rights prices in every country BUT that is what Management is for. It is not just to wait and see what happens: It is a dynamic world, and not static as Auditors and Accountants wants us believe.

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