Netflix Inc (NFLX 1.74%) has been one of the most volatile stocks on the market over the past decade. The leading video streamer has reinvented itself more than once, first transitioning from a DVD-by-mail service to a streaming one, and then going into original programming and cutting out the middleman.
Just this year the stock has risen 64% year-to-date, though it's down more than 25% from its high this summer at $423 per share. Not surprisingly, the barely profitable streamer has been a battleground stock for much of its life, attracting plenty of bulls, but also its fair share of detractors. Among them is NYU Finance Professor Aswath Damadoran, author of The Little Book of Valuation, who argued in an April blog post that Netflix was only worth $172 per share, barely more than half of its current share price of $315.
Image source: Netflix.
What's the rub
Damodoran uses a discounted cash flow valuation and a number of assumptions to come to this conclusion. First, he calculates that Netflix's cost to acquire a new subscriber in 2017 was $111.04 based on the company's marketing costs of $1.28 billion and capitalized content costs, or content costs not directly expensed, of $2.15 billion, which helped it add 30.84 million net new subscribers. In 2017, the company's revenue per subscriber was $113.16.
Based on his DCF model, Damodoran estimates that existing subscribers each have a value of $508.89, and that new subscribers are worth $397.88. That gives Netflix's subscriber base a present value of about $196 billion -- but Damodoran subtracts $111 billion for the present value of corporate expenses, leaving the company with about $85 billion in operating assets. After adjusting for cash, debt, and the value of employee options, Damodoran comes up with $77.2 billion in Netflix's common stock equity, or $172.82 per share based on 447.8 million shares outstanding.
The thing about discounted cash flow
Damodoran's model is thorough and his logic is sound. He's even fairly generous with his growth estimates, figuring that Netflix's subscriber base will grow by 15% a year for the next five years and 10% over the following five years, giving it 381 million subscribers by 2028, and he assumes that revenue per subscriber will increase by 5% a year.
However, discounted cash flow valuations work best when they're measuring a reliably steady, profitable stock, and even then they're often wrong because they involve so many assumptions about the future.
With growth stocks they're even less reliable. For instance, Damodaran valued Under Armour in his 2011 volume Little Book of Valuation, and estimated that the sportswear company's revenue growth would slow faster and more gradually then it actually did.
The DCF model can't account for things like competitive threats, the macroeconomic climate, or technological breakthroughs. Most importantly -- especially for a company like Netflix -- it doesn't account for optionality, which is the potential for entirely new businesses to be added on in the future. Part of the reason Netflix has been such a big winner over its history is because of optionality. The company's pivot from a DVD-by-mailer to a streamer and then to one of Hollywood's biggest studios would have been nearly impossible to foresee when the company first went public in 2002.
Similarly, though Netflix has been singularly focused on it original content strategy for the last few years, the company has plenty of options to branch out from there if it so chooses. It could add live sports or news to its lineup, vertically integrate into movie theaters, make a discounted package with advertising available like Hulu, merchandise branded toys like Disney, or offer a la carte movies and TV like Amazon Video. The prospect of improving technology in areas like virtual reality could also open the door to higher-value subscriptions.
To be clear, Netflix has shown little desire to moved beyond its current business model, and focused instead on growing its subscriber base. But the opportunity for the company to expand its horizons is certainly part of the reason it carries the lofty valuation it has today. If Damodaran's prediction proves to be correct, Netflix is sure to be an entertainment powerhouse with 380 million global subscribers -- but that would make the potential for the company to be more than just a streamer even greater.
Show me the money
Damodaran concluded:
In summary, Netflix has built a business model of spending immense amounts on content, using that content to attract new subscribers, and then using those new subscribers as its pathway to market value. It is clear that investors have bought into the model, but the model is also one that burns through cash at alarming rates, with no smooth or near term escape hatch.
Damodaran is correct about Netflix's cash burn, as it's expected to burn through $3-$4 billion in negative free cash flwo this year and next, but he's wrong about the company's lack of an escape hatch from that pattern. Its cash burn is expected to moderate after 2019, and content spending growth logically has to eventually slow -- the marginal value of new shows and movies diminishes as the company's content library gets bigger.
Still, investors should be mindful that the company's valuation presents considerable risk, especially if the market sell-off we saw in October persists. While I don't think Netflix's share price is falling to $172 anytime soon, the company will eventually have to deliver significant profits to warrant the stock's high valuation.
