As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.
We can't know for sure whether Buffett is about to buy Netflix (Nasdaq: NFLX ) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us.
In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno-mumbo-jumbo businesses.
Leaving aside Netflix's size, which might be too small for Buffett to literally buy, does it meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Netflix's earnings history:
Source: S&P Capital IQ.
Netflix's earnings have grown substantially over the past five years.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.
|
Company
|
Debt-to-Equity Ratio
|
Return on Equity
|
5-Year Average Return on Equity
|
| Netflix |
62% |
49% |
39% |
| Coinstar (Nasdaq: CSTR ) |
75% |
23% |
14% |
| Time Warner (NYSE: TWX ) |
65% |
9% |
3% |
| Amazon.com (Nasdaq: AMZN ) |
23% |
9% |
28% |
Source: S&P Capital IQ.
While old bricks-and-mortar competitors like Hollywood Video and the now-bankrupt Blockbuster -- as well as old-media companies like Time Warner -- aren't blindingly profitable, the new, capital-light video rental industry is. Netflix and Amazon, with their centralized distribution, generate high returns on equity (Amazon's most recent, investment-geared year notwithstanding). Coinstar, which operates video-rental kiosks, is also growing quite rapidly. Although its average historical return on equity isn't particularly impressive, the company's capital efficiency has improved considerably as it has scaled.
3. Management
CEO Reed Hastings has been at the job since 1998 and co-founded Netflix in 1997. It's usually a good sign to see young companies run by driven founders.
4. Business
Netflix has been an incredibly disruptive force in the video-rental market, completely upending its high-fixed cost competitors. Now it's investing in digital delivery in hopes of ensuring that it's not disrupted in turn.
The Foolish conclusion
So is Netflix a Buffett stock? Probably not, but only because it's an upstart in a turbulent and uncertain industry. So far, Netflix has been on top, as illustrated by the characteristics of a quintessential Buffett investment it does possess: consistent or growing earnings, high returns on equity, and tenured management. To stay up to speed on the top news and analysis on Netflix or any other stock, simply add it to your stock watchlist. If you don't have one yet, you can create a watchlist of your favorite stocks by clicking here.
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