Netflix (NASDAQ:NFLX) skeptics like to call the stock "expensive." And when you look at traditional value metrics that are based on earnings or cash flows, that's certainly true. But is that really the right way to look at ambitious growth stocks like Netflix? Do valuation methods like discounted cash flow analysis or price-to-earnings ratios even apply to the exploding media subscription market?
After looking at evidence from Netflix, Sirius XM (NASDAQ:SIRI), and Pandora Media (NYSE:P), I would argue that these stocks require a different approach. Finding better methods to judge their future profits will help you understand these stocks on a whole new level.
And I'm not talking about newfangled metrics such as subscriber growth or discounted fluke triumph expectations. There's a thoroughly traditional tool available to help you take stock of new media growth phenoms, but this approach is hardly ever mentioned in the same breath as Netflix or Sirius.
Today, we'll be looking at the price-to-sales ratio -- because it works.
What's wrong with the good old tools?
First, let's think about how the usual tools fail us -- and why.
Netflix provides the best examples, so let's start there. Have you ever seen a crazier chart than this one?
In the second half of 2011, Netflix was reporting the highest earnings in company history. But share prices came crashing down as investors thought that the Qwikster-branded split between streaming and disc-based services was a bad idea. At that time, Netflix shares could be bought for just 16 times trailing earnings -- bargain-basement discounts for sure.
Fast-forward 14 months, and Netflix suddenly traded at more than 650 times trailing earnings.
The company was starting to commit all surplus capital to two new growth strategies: overseas expansion and original content production. The long-term value of these projects quickly became obvious to Netflix investors, while free cash flows and net profits sank into breakeven or red-ink territories.
The P/E ratio crutch showed its true colors, vaulting from one extreme to another -- equally useless -- figure. With free cash flows dipping below zero, any cash-based analysis would have called Netflix "worthless" in 2013.
So focusing on high-octane growth tied Netflix to insanely inflated price-to-earnings valuations and no cash-based value at all.
To reach these conclusions at the end of a serious analysis, you'd have to assume that the growth tactics would fail utterly. Or, you could say that the company would be locked into this growth-centric mode forever with no option to switch into higher margins and lower growth in the far future.
Be my guest, but both of these negative assumptions are false in my eyes. "Earnings is a managed outcome," said Netflix ex-CFO Barry McCarthy way back in 2010, and that's still true today. Netflix can and will adjust its strategy to the real-world situation. Right now, and for the next several years, that means focusing on fast growth and letting the profits come years later.
Analyzing Netflix from a price-to-sales angle can sidestep the thorny issues of what the company's unstable earnings or cash flows might be worth. But first, let's examine the other examples of new-age stocks that require a different class of old-school tools.
Going up and down, all at once
A five-year chart for Sirius XM looks just as crazy. The satellite radio titan reported one blowout quarter in 2012, sending trailing earnings sky-high while P/E ratios plummeted. For a while, you could grab Sirius shares for less than 5 times trailing earnings, which was way out of step for this growth-oriented media stock.
As silly as that temporary mismatch may seem -- triggered by a $3 billion one-time tax benefit -- it's the P/E figures around that gap that interest me.
You see, Sirius's shares have almost doubled since that one-shot tax boost. But the 86% stock gain comes with a 114% wider P/E ratio. Before that interesting quarter in 2012, Sirius shares traded for 23 time trailing earnings; Today, the going price is 49 times trailing earnings.
P/E expansion sure creates value in the pockets of Sirius shareholders, but also undercuts the value of that ratio as a stock-pricing tool. That's particularly true when a cash flow analysis moves in the opposite direction, as it does with Sirius in recent years. Sirius share prices fell from 28 times to just 19 times trailing free cash flows.
Rising cash flows versus sliding earnings -- it's enough to give traditional value investors a headache. Which metric should you look at?
Neither one, at this point. Again, price to sales is where it's at. We'll get back to the reasons why in just a minute.
No starting point at all
Music service Pandora Media is an even tougher nut to crack than Sirius or Netflix when you're bound and determined to base your analysis on profit figures.
The company tends to report negative (adjusted!) earnings and maintains a pile of brightly burning cash. Pandora's balance sheet is nearly debt-free, but propped up by additional (and dilution-prone) stock sales. In the third quarter of 2013, for example, Pandora sold new stock certificates worth $379 million.
In other words, any analysis that starts with positive earnings or cash flow figures will be worthless when you're thinking about Pandora.
But the company is clearly not worthless. That might be Pandora's final destination, but the company still has a fighting change to turn the tide in the long run.
Because -- and this will sound familiar by now -- Pandora can choose to stop looking for maximum growth at any time, and start thinking about sustainable profits instead. That time has not yet come, so earnings-focused analysts are left up the creek without a paddle.
Jump into a different canoe and aim for the safe harbor of price-to-sales analysis. That'll work.
Price to sales? How does that old sawhorse help?
You must think I'm kidding. Price to sales figures are more often used to look at low-growth giants. These are lumbering titans of retail, industrial hulks, elephants of energy. You know, the exact opposite of the fast-paced media businesses we're looking at here.
But I'm dead serious. Adding P/S figures to the discussion will help you understand all three of these subscription-based stocks.
In Pandora's young life as a publicly traded company, stock prices have swung from about $8 per share to more than $40. That's a fivefold increase in three and a half years, followed by a quick 50% drop from last January's all-time highs. Earnings and cash flows have been erratic and mostly negative, as established earlier.
That roller coaster ride is too uncomfortable for many investors. With no income of any kind to serve as a launching pad for most types of value analysis, investors fumble in the dark.
Except, Pandora's nutty chart starts to make sense when you factor in the company's torrential revenue growth.
Against the backdrop of Pandora's trailing sales quadrupling, the general rise in share prices starts to look reasonable. With a couple of notable exceptions, you'll see the price to sales ratio sticking around in a fairly narrow range, bouncing between 4.5 and 6.5 times trailing revenues.
With this tool in hand, the soaring Pandora prices in the second half of 2013 look like a fluke. Investors saw Pandora's business improving -- and counted the chickens twice. Rather than sticking to the (briefly) time-tested price to sales value, the ratio itself soared to unreasonable levels.
This happens when an unprofitable subscription service like Pandora draws closer to breaking even and more. Investors get excited, share prices jump too far.
Higher margins were always part of the plan, though. It's a dream deferred, sure, but that dream has always been part of the plan. Not just for Pandora, but for all of the companies under my microscope today.
And Pandora does deserve a small premium for showing that the company can deliver actual profits when it needs to. Management must eventually provide an answer to Langston Hughes' legendary question about the deferred dream: Will it just sag like a heavy load, or does it explode?
Presenting a partial answer to that crucial question is worth a little extra, as layers of uncertainty start falling away. The premium for a brief surge to near-profitable performance just shouldn't involve nearly doubling the price to sales ratio in a matter of months.
So Pandora backed off from its almost-positive profits, shares plunged back to more reasonable P/S levels, and now trade at the very bottom of the "reasonable" range. Pandora's sales are still growing as quickly as ever. If you believe that the company can control its own destiny by trading in extreme sales growth in exchange for large profits when needed, this could be a strong entry point into Pandora's stock.
And all of these moves make a lot more sense when you're taking Pandora's sales growth and the correlating price-to-sales ratio into account. From overheated rise, to dramatic correction, ending in a potential buy-in opportunity -- it's all there.
That moment when the game utterly changes
Sirius XM is a very different story, but just as illustrative as Pandora.
The satellite radio service has already slowed down its customer acquisition pace, leading to just 65% higher sales over the last 5 years. That's the phase change we're looking for in all of these endgames -- Sirius is more interested in growing its profit margins nowadays, and less prone to huge marketing pushes that would boost sales in a big way.
So here's where Sirius investors get to sink their teeth into P/S ratio expansion, based on the company's growing profit margins. Here, the P/S ratio soars on the back of wider operating margins. In turn, that ratio expansion explains the Sirius stock chart over the last 5 years:
As operating margins grew from 10% in 2010 to 27% at the end of 2013, Sirius shares followed suit in lockstep. Sirius investors are no longer looking for dramatic top-line growth, but focused on bottom-line improvements. So, when margins started to level off in 2014, so did the stock price.
Once again, the price-to-sales line contains vital clues to the entire Sirius story. You still have to dive in and find out the reasons behind each swing, because the numbers never tell the whole story. But price to sales gives you a fantastic starting point for further research on Sirius XM.
Which one is the real Netflix?
And that brings us back to Netflix. It's a tale of two cities:
Stretching the chart back to 2008 in order to capture Netflix as a pure DVD shipper, you'll find Netflix shares existing on two separate levels.
In one alternate reality, Netflix is seen as a huge growth engine with share prices rising to, then hovering around 5 times trailing sales. Here, the stock rests on a rich layer of growth-based price premiums.
In the other version of events, investors forget all about future growth. Netflix is written off as a has-been that's hardly worth its own weight in revenues. This was the case under the pure DVD-shipping model, again in the shadow of the Qwikster-branded separation debacle, and yet again when Netflix made it clear that earnings and cash flows will be scarce for several more years.
Both of these market reactions can be seen in the price to sales ratio.
Much like Pandora, P/S figures have moved around far less than the share price. Unlike Pandora, Netflix has delivered consistently positive earnings and mostly positive cash flows, giving investors some semblance of a familiar valuation crutch to rest on. But those metrics have soared to crazy nosebleed levels in the streaming era, as Netflix skims very close to the breakeven points for both earnings and cash flows.
Meanwhile, price-to-sales provided a sense of relative calm that comes closer to explaining what's really going on behind the curtain.
According to the wild profits-based charts, Netflix nearly died in 2013. The saner sales-based approach, and a look at the actual news flow from that period, shows Netflix simply pumping its surplus cash and earnings into two new growth projects: Overseas expansion and original content.
Investors caught on to the benefits of this strategy early on, and share prices soared. All in all, Netflix stock prices have risen 550% in 5 years, a span that includes both the Qwikster error and last month's panic over disappointing subscriber growth figures.
You could argue that Netflix shares shouldn't trade at 4.5 times trailing sales, as they do now and did right before the Qwikster-related plunge. That's a fair critique, but only if you think that Netflix doesn't control its own destiny.
And now we're back to the start of this very article again. In my eyes, Netflix deserves a premium price to sales ratio because the profits are coming. When Netflix forecasts a certain level of profits, the company tends to deliver on its promises -- and more.
A common brickbat flung in Netflix's direction this October was that the company should have clutched on tighter to its own earnings projections and spent more of its estimate-beating earnings on marketing. It's like the company can't hold its profits back tightly enough, letting too much money trickle all the way down to the bottom line.
From that angle, you could argue that Netflix really hasn't earned a P/S premium on rising margins, like Sirius, nor on unfettered growth, like Pandora. Maybe 4.5 times trailing sales is too much, and the current level is a freak accident that's soon to be corrected -- again.
In my view, the rebel earnings surprises do show that Netflix's management is human and can fail to set perfect goals for the future. But it's also a nice problem to have, since the company tends to err on the conservative side.
For me, Netflix deserves a higher price to sales premium exactly because the profits are so obviously within reach. When the global growth spree ends, perhaps in five years or so, Netflix gets to rebalance its business model and think about large profits instead. All of this is built into the price-to-sales ratio you see today, and watching this metric will help you stay informed about Netflix in the years ahead.
And of course, you're free to disagree with my conclusions. Goodness knows that some of my Foolish colleagues do.
But I think I'm right, of course. And price to sales figures helped me get there.
Anders Bylund owns shares of Netflix. The Motley Fool recommends Netflix and Pandora Media. The Motley Fool owns shares of Netflix, Pandora Media, and Sirius XM Radio. That escalated quickly. Try any of our Foolish newsletter services free for 30 days.