Netflix: An Updated Valuation
What do I have to believe to expect a average long-term return? And what's my base case suggest about forward returns?
The single greatest error I have observed among investment professionals is the failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the company’s stock price. - Mauboussin
I posted some mostly qualitative thoughts about Netflix after its first-quarter results (Netflix: To the Victor Go the Spoils). But however competitively advantaged Netflix is, however long their growth runway may be, whatever their long-term margin and cash flow profile might look like can be irrelevant if our expectations are already reflected in the stock. If that’s the case, the company can perform as well as we expect but we still might only earn average returns over time. Or if even higher expectations than ours are already baked in, the company could meet our expectations but the stock can still underperform. That’s the disaster we’re trying to avoid.
Instead, we want to ensure a modest or, ideally, an unrealistically negative outlook is baked in at the current stock price. And a more realistic outlook would suggest the stock is worth a multiple of where it is trading. That way there is plenty of room for the future to miss our base case while still earning an acceptable return—our margin of safety. And with any luck, the future turns out better, in which case we’re buying a boat. In other words, price is a key lever we use to skew the odds in our favor.
It should go without saying that regardless of how good a company’s future prospects look, the stock’s future prospects depend on the price. Everyone knows that’s true. But it’s often either forgotten, overlooked, or we convince ourselves our expectations were too conservative and revise them ever higher. Sometimes that is justified, but it’s also easy to take it too far because we often want it to be true. So it is important to remain as objective as possible and not succumb to endowment bias—where we overvalue what we already own—and confirmation bias—where we seek out information we already agree with and dismiss contrary evidence. And if you’re imagining a love story between you and your favorite stock, it’s in your mind alone. A stock doesn’t know you own it and won’t hesitate to put a hole in your portfolio if you’re holding the bag when investors realize the baked-in expectations were far too high. I think the goal is to try to continuously and dispassionately assess the long-term odds and be willing to cut ties if the circumstances justify it.
When we do the work to figure out what sort of expectations are baked in at any given price, it becomes apparent that the implied expectations can differ wildly between one price and another. That seems underappreciated to me. It seems like a more a common alternative approach is to not actually value the business at all but assume accelerating growth deserves a higher multiple and decelerating growth deserves a lower multiple. That sort of heuristic is easy to apply and may even make sense on average but is incredibly prone to error. For example, what would you pay for the stock market equivalent of a beautiful oceanfront rental property that generates high and accelerating rents but is 100 feet from a cliff that has been eroding 5-15 feet per year? That could look appealing in the near-term but deserves a low valuation to the extent one expects the erosion to continue.
High Level Valuation Thoughts
Given the value of a business is the present value of all future cash flows, I focus on how the key value drivers could play out over the long term. Obviously, any forecast is certain to be wrong to some extent, which explains why I underwrite several possible scenarios that we can all ponder. Importantly, with this process the value drivers are explicit and can be debated and continuously revised with new information. All the cards are face up on the table. I prefer that to picking a multiple where the value drivers are implicit, hidden from scrutiny, and frankly, we have no idea what value drivers we’re betting on.
For example, what does a given multiple imply about Netflix’s subs, ARM, content spending, and operating leverage looking out 5 or 10 years? Someone out there may have a thoughtful answer but I certainly wouldn’t—not without first laying out the value drivers and discounting the cash flows. Only then could I say, “My base case values it at X, which happens to be a Y multiple. But the multiple is an output, not an input, of the valuation process. The inputs are the long-term value drivers.”
At a high level, Netflix’s revenue can be forecast using two variables for each of the four geographic segments. We simply forecast 1) paid memberships and 2) average revenue per member (“ARM”) for each of UCAN (U.S. and Canada), EMEA (Europe, Middle East, and Africa), LATAM (Latin America), and APAC (Asia-Pacific).
While UCAN’s fastest days of paid member growth are certainly behind it, I think investors are too quick to assume UCAN is a no-growth segment. There are 131.2 million households (2022 Census data) in the U.S. and another 15.1 million in Canada (2021 data) for a total of 146.5 million UCAN households. That’s going to grow over time and the already high broadband penetration rates are likely to approach 100%.
The Joint Center for Housing Studies of Harvard University forecasts U.S. households increase to 139.8 million by 2028 and 149.4 million by 2038. The Canadian Housing and Mortgage Corporation (CMHC) forecasts Canadian households increase to 16.2 million by 2026, 17.0 million by 2031, and 17.7 million by 2036. Using those two forecasts, the UCAN segment as a whole should have something like 160.7 million households in a decade and 172.0 million a decade beyond that.
For context, Netflix had 74.4 million paid memberships in UCAN at the end of March. So that would be 51% household penetration today and 43% household penetration looking out a couple decades. Both of these figures seem…