Buying stock with nothing but a diffuse hope that prices will go up is not investing. At best, you're a reckless gambler; at worst, just another fanboy who's better off just buying an index fund and calling it a retirement portfolio.
Real investors have at least some clue on what their stocks really are worth. That way, you can cash out if a bubble ever forms in your favorite sector and drives your shares way past any reasonable prices.
For example, I am 100% confident that Netflix (Nasdaq: NFLX ) shares will at least double by 2016. In fact, my research says that a triple-bagger is even more likely. Let me show you how.
First off, let's acknowledge that Netflix investors had a bumpy ride in 2011. Share prices touched the $300 benchmark very briefly and then crashed to $62 on the Qwikster debacle. That's an 8.8 on the pain-o-meter (after throwing out an undeserved 3 from the Elbonian judge who's used to far worse), and lots of investors lost all hope that Netflix would ever be great again.
But CEO Reed Hastings quickly erased the Qwikster mistake and got back to what he does best, which is to sign up large numbers of new subscribers. In the fourth quarter, the company gained 610,000 new American subscribers even in the face of Qwikster-related cancellations early in the quarter. In the next report, due next Thursday, management expects to show at least 1 million new domestic streaming accounts and maybe as many as 2 million. So growth is not dead at Netflix -- it just took a break.
And that's exactly how Hastings likes it. The streaming business model rests on big, expensive content contracts, but the overhead costs beyond that are nearly nil. So to support the content deals he already inked, Hastings must keep those subscriber counts growing to balance out the fixed content costs. It's a lot like how Sirius XM (Nasdaq: SIRI ) launches expensive satellites and signs big-name content deals with big price tags. Those costs can simply not be moved, so Sirius -- like Netflix -- must keep growing just to stay alive.
Sizing up the ballpark
So to estimate the value of the streaming business, you have to get a handle on how many customers the company can snag.
Hastings himself estimates that the streaming service should grow to somewhere between two and three times the size of HBO, thanks to his more flexible distribution model that isn't locked to expensive cable packages. So the domestic target, then, is in the ballpark of 60 million to 90 million subscribers.
Note that this is not the same thing as the "addressable market." According to media market tracker Nielsen, the American market consists of 115 million households. Reaching 90 million of those, as in Hastings' more optimistic estimate, would make Netflix nearly as popular as television itself, or toothbrushes.
If you think even the lower target of 60 million subscribers is an audacious, unreachable goal, then Netflix isn't for you. To me, it looks eminently reasonable. Netflix doubled in size to 22 million streaming subscribers between the first quarter of 2010 and the fourth of 2011 -- a period of less than two years that includes the Qwikster blunder and the move to a new pricing model. Without those unpopular moves, Netflix could have grown even faster.
If Hastings just stops playing around with the fundamental business model, the increased spending on better content should combine with online entertainment moving further into the mainstream to double again in short order.
I was told there would be no math!
My models show that Netflix is dramatically undervalued at today's prices. If the company can get close to the 90 million domestic streamers target by 2016, the division would stream about $1 billion right to the bottom line. Stop at 60 million and you still get nearly $600 million in net earnings.
I'm assuming that content costs will balloon to $6 billion in 2016. The cost ceiling there might actually be a lot lower than that, but let's stay conservative. It's always cool to get positive surprises.
What's a reasonable P/E multiple in the entertainment world? Well, content powerhouse Disney (NYSE: DIS ) trades at 16 times trailing earnings today and Time Warner (NYSE: TWX ) sells for 13. But they aren't exactly comparable to Netflix, working on the other side of the fence between production and distribution and also running extracurricular divisions like theme parks, cruise ships, and magazine publishing. Sirius is a closer match for Netflix's personality and trades at 33 times earnings, and you could argue that IMAX (Nasdaq: IMAX ) , with its nosebleed P/E at nearly 100, is shaking up cinematic distribution much as Netflix is doing to the home-entertainment market. But both of those peers still get a high-growth premium, and we're assuming that the exciting growth phase will blow over at the end of this thought experiment.
The final verdict
With those assumptions and caveats in mind, a mature Netflix trading at 15 to 20 times trailing earnings in 2016 should see a share price of $150 at a bare minimum or $350 at the upper end.
That's only from domestic streaming. DVD rentals will be rather insignificant by that point, so let's leave that segment out of the math, but we're also ignoring the rest of the world here. Netflix has put international growth on hold until the current batch of pan-American and British Isles markets turn a profit, but it's a big world out there with plenty of value to add.
Realistically, and including a modest contribution from the international market in these numbers, I expect the stock to triple back up to $300 in four years for a very healthy annual return of 31%. This is why I still own Netflix even after the Qwikster travails, and why I have a bullish CAPScall on the stock as well.
This is not a "get rich qwick" scheme but a market-crushing investment for the medium term nonetheless. Netflix may have a bumpy ride before getting there, at least until the international expansion restarts again in 2013 or 2014. If you're looking for one stock to juice your portfolio this year, you might prefer The Motley Fool's Top Stock for 2012.