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.
