In my column last week, I jumped to the defense of "yesterday's news" Netflix (NASDAQ:NFLX). More precisely, I made the case for how swiftly groupthink can turn a story stock into a hidden gem, and why I'm still very much a believer in the online DVD upstart.

Simply put, I'm not buying the notion that Netflix will be gobbled up and spit out by Wal-Mart (NYSE:WMT), Blockbuster (NYSE:BBI), and video on demand (VOD). For more on why, I encourage you to read last week's Defying the Naysayers. Today, I hammer that position home and tie it all together with a look at valuation.

Breaking Blockbuster and VOD
Netflix understands that happy and paying subscribers must not run out of movies to watch. Blockbuster's inability or unwillingness to grasp this will doom any subscription service it rolls out to mediocrity. After all, the fact that 80% of Blockbuster's rentals come from its top 30 titles is not at all surprising when you consider that about 80% of the store is dedicated to new releases.

Blockbuster's Movie Pass program (rent two or three titles at a time for a monthly subscription fee) seems like a great deal until you burn through those 30 new releases you've been wanting to see. Because Blockbuster is not effective at promoting older titles (or even keeping them in stock), you'll likely run out of movies to watch within a few months and cancel your subscription. That's hardly fertile ground for a successful long-term subscription business.

Because of extremely limited selections, VOD subscription services will probably be just as short-lived as Movie Pass. Users will eventually run out of movies to watch and cancel their subscriptions. Rental services that thrive on new releases are better served sticking to a traditional pay-per-view model.

Why don't you tell me what I want to see?
What makes Netflix more likely to build a successful subscription service with long-term viability? The 20,000 DVD library helps, but I don't think selection is the most critical factor. After all, having an extensive library does Netflix no good if its subscribers don't know how to locate movies in that library.

To keep subscribers happy, Netflix feeds them a steady diet of promising recommendations, primarily by means of Cinematch. By comparing your movie ratings to those of other subscribers, Cinematch predicts which movies you are going to like and recommends titles accordingly -- you've likely experienced this sort of value add using (NASDAQ:AMZN) or AOL (NYSE:TWX).

Of course, this is less about customer experience than creating demand -- the kind of ploy consumer giants like Coke (NYSE:KO) and Pepsi (NYSE:PEP) made famous peddling sugar water. And according to company surveys, more than three of 10 subscribers watched fewer than three movies per month before signing up. As Netflix subscribers, they watch significantly more -- on the order of six to seven per month. That may not be great for margins, but it certainly keeps people engaged.

Play it again, Sam
Unlike Blockbuster or VOD, Netflix derives the majority of its business from older titles. A full 99% of its titles are rented in any given year. That means Netflix subscribers watch roughly 19,800 of the 20,000 titles that Netflix keeps in stock. The popularity of older titles among Netflix subscribers often matches or exceeds that of newer titles. Talk about unprecedented depth and breadth in movie viewing.

In short, Netflix has succeeded in not only changing the viewing habits of its subscribers, but also in stimulating demand. How about loyalty? Over the last four years, monthly subscriber churn has steadily dropped from 7% to 4% today. The churn is less than 4% for subscribers who have been with the service for more than a year, indicating that people are less likely to drop the service the longer they have been with it.

But, who are these people? Are they all young, highly educated, well-to-do movie buffs? If so, I'd be a little worried about the company's expansion potential. Fortunately, that characterization could not be further from the truth. More than half of all subscribers are more than 34 years old and earn less than $75,000 per year. More than 40% do not have a college degree. In other words, Netflix subscribers are mainstream.

If Netflix has successfully attracted average Americans and transformed their viewing habits, I see no reason why the company should not meet with continued success for the foreseeable future. With a library unparalleled in selection and a convenient way to navigate and find movies on the website, Netflix has mainstream appeal and is on the right track to building a successful long-term subscription business.

But is it a value?
Assuming I am correct about its competitive position, Netflix should have no problem reaching its goals of 5 million subscribers, $1 billion in revenue, and $100 million to $200 million in free cash flow (FCF) by 2006. To achieve this goal, the company needs to reach just 5% of American households -- a tiny slice of the overall DVD rental market. Remarkably, penetration in the San Francisco market is higher than 7%, with no signs of abating. Growth in Netflix's newer markets is tracking San Francisco's historical growth rates quarter for quarter.

With management well on its way to meeting and exceeding its goals, I easily see Netflix boasting a market cap of $3 billion by the end of 2006. I say easily because I arrive at this by applying a conservative 20 times exit multiple to $150 million of FCF in 2006 -- the middle of management's estimated range. Given a tendency to underpromise and over deliver, it is possible -- and perhaps even likely -- that the company will reach 5 million subscribers as early as 2005.

Moreover, the market will probably pay more than 20 times trailing FCF for a company growing at 50% year over year. If so, $3 billion in market cap will prove conservative. Either way, my valuation implies a 20% annualized return for the next two and a half years, even factoring in annual share dilution of 5%. I would be very happy with 20% annualized returns for the next two to three years with the possibility, or probability, of even higher returns.

Final thoughts
Anyone with enough money can acquire a DVD library, set up a website, build distribution centers, market the service, and enroll subscribers. This would suggest that Netflix has no moat around its business. However, I would counter that the company's sustainable competitive advantages do not lie in the areas of distribution or marketing, but rather in (1) the strength and staying power of Internet brands; (2) the superior selection that DVDs will continue to have over VOD because of the innate economic characteristics of the medium; and (3) its strategic focus on creating and sustaining demand for movies among its subscribers.

For all that, is Netflix truly a hidden gem? OK, maybe we missed that particular boat. On the other hand, the market is underestimating the strength of the company's advantages, and -- this morning's bounce notwithstanding -- the stock has pulled back a bit. Most importantly, the shares are trading at a significant discount to my estimate of their intrinsic value. Hidden or not, Netflix is a gem at less than $35 per share.

Looking for the next Netflix or even a fallen angel set to get its wings back. Click on the link to learn more about Tom Gardner's Motley Fool Hidden Gems and to sign up for a free trial if you like what you hear.

Fool contributor Daniel Hong owns shares of Netflix. The Motley Fool is investors writing for investors.