Netflix Valuation Sanity Check
There are two ways to think about Netflix’s valuation. To oversimplify dramatically, one is “It’s P/E is 100, and everyone already has Netflix, so it’s way overvalued”, and the other is “Netflix is an awesome and important tech company, and it's market cap is only about $150 billion, and that's really cheap for awesome and important tech companies these days”. The weird thing is both arguments are pretty compelling. The stock is priced very highly based on any standard metrics: price/sales over 9, price/earnings north of 100, price/blindfolded Sandra Bullock movies of 150,000,000,000. And without looking at any numbers, one gets the sense that Netflix is closer to the end of their growth story than the beginning. For example, the list of people I know who don’t already subscribe to the service consists of a) my parents, and b) my wife’s parents; this does make me a bit nervous about the company’s future growth possibilities. On the other hand, I have a pretty strong qualitative belief that Netflix will someday be the largest global media company, because that company will be a video streaming company, and Netflix is already the biggest and best of those (for this purpose I’m not counting Google and Facebook as media companies, although you can certainly argue that they are. Let's say instead the largest media company that still makes money by the old-fashioned method of actually charging their viewers money). Given that there is currently a lot more than $150 billion of market value sloshing around in the video media industry, and the tendency of internet economics to create winner-take-most dynamics, it just feels like the largest global media company of the future will be worth more than $150 billion. If that's the case, then Netflix actually still has a long way to go. As the owner of a handful of Netflix shares, I sure would like to know which of these narratives is closer to the truth. There are no shortage of analysts working on this problem; looking at Seeking Alpha articles alone, you can find some projections that confirm pretty much whatever you are predisposed to think of the stock. Some of these models are pretty complex and impressive, and no doubt those produced by actual Wall Street analysts on both the buy and sell side are even more so. However, rather than extrapolate current growth rates, cash flow, etc…I want to try a more crude approach, which is to estimate by building from the bottom up “How big is Netflix likely to be in 2028?” I don’t expect this to be the best possible estimate of the company’s growth, as I’m ignoring a lot of potentially useful data such as actual recent growth rates, but by constructing it from basic assumptions and ratios, I expect it to be useful as a sanity check on the more complex and detailed models. I'm building a back-of-the-envelope model, if the envelope in question is one of those awkwardly large ones that will almost, but not quite, fit in your mailbox, so the very edge of it gets soaked when it rains. By “how big” I mean, ultimately, what market cap can Netflix achieve? The basic ingredients to my estimate are number of households with broadband, Netflix subscription penetration rate among those households, revenue / subscriber, profit margin, and price / earnings. First, the numbers:
US
2018
2028
total population
328
351
households
127.5
136.4
broadband households
109.8
122.8
broadband %
86.12%
90%
Netflix paid memberships
58.5
86.0
Netflix penetration
53.28%
70%
price / sub (US)
$11.00
$25.00
annual revenue (US)
$7,722
$25,786
International - Western Developed
(Canada, Australia, New Zealand, Western Europe)
2018
2028
broadband households
173.7
191.1
Netflix subs
60.795
95.5
Netflix penetration
35%
50%
price / sub
$10.00
$20.00
annual revenue
$7,295
$22,928
International - Rest of World
2018
2028
broadband households
336.5
403.8
Netflix subs
20.0
80.8
Netflix penetration
5.94%
20%
price / sub
$5.00
$9.00
annual revenue
$1,199
$8,722
International Subtotal
2018
2028
worldwide broadband households ex China
620
717.7
broadband households (ex China, ex US)
510.2
594.9
Netflix subs
80.8
176.3
Netflix penetration
15.83%
29.64%
annual revenue (intl)
$8,494
$31,650
Total
2018
2028
total revenue
$16,216
$57,437
operating margin
9.9%
35.0%
operating income
$1,605.00
$20,103
P/S
9.28
7.00
P/OI
93.8
20
market cap (billions)
$155 (March 2019)
$402
subscribers
139.3
262.2
shares outstanding
437
467
share price
$354.69 (March 2019)
$861
Some inputs to this model, such as the number of broadband subscribers in the US, rest on pretty solid underlying data. Others, such as the penetration rate in Europe, are much more subjective (possibly BS). Again, what I’m shooting for here is a sanity check. In any case, here is my reasoning behind each component: Subscribers I’m considering the pool of potential Netflix subscribers to be households with fixed broadband internet access. I'm sure there are probably some Netflix subscribers even today who do not have fixed broadband internet, opting instead use a mobile internet connection exclusively to access the content, but I don’t believe it’s a significant number. That mode of use could become more common as more bandwidth-friendly 5G cellular networks are rolled out, but I still don’t see mobile-only subscribers meaningfully contributing to their customer base. In their financial reports, Netflix breaks out subscriber and revenue numbers only into "US" vs "International", but for modeling future growth I think it is important to break them out one step further. I’ve segmented the world of Netflix subscribers into 3 parts:
- The United States, where Netflix will probably always have the most success on a per-household basis
- "Western Developed" aka Western Europe, Canada, Australia and New Zealand, the group of countries where they might see penetration rates and pricing power approaching that of their US business
- Rest of World ex-China where the 'flix will still achieve meaningful penetration and revenues, but not likely to achieve rates similar to that in the US (The service is currently unavailable in China and even if that changes, I don't expect massive success there)
Data on individual penetration rates from Business Insider and Statista suggest that Netflix is seeing more early success penetrating western developed countries than other international markets, and I expect that to continue. Even as they become a more international company, the best and most plentiful content available on Netflix will probably remain produced in the US, or still in English but with better accents, and will be most attractive to customers in countries which are culturally similar to the US (and which have relatively high numbers of English speakers). "Netflix penetration rate" in these estimates means Netflix subscribers / # of households with broadband (rather than Netflix subscribers / total households). For the US, this number is known for 2018, as subscriber counts are broken out for the US, and we have a reliable number for households with broadband access as well. Exact penetration rates for the regions I've broken out are not available, I've filled in estimates for each that give the correct total number of international subscribers for 2018, and are generally in line with penetration rates for some individual countries (data from Business Insider and Statista). Numbers for households with broadband internet in 2018 come from the International Telecommunication Union, while those for total US households in 2018 come from FRED. Total US households for 2028 are estimated using projections from the US Census, assuming a fixed ratio of households to total population. I'm assuming total numbers of households with broadband internet access in "Western Developed" countries increase by 10% over the next 10 years (slightly less than in the US), and those for "Rest of World ex-China" increase by 20%; both of these estimates are subjective but meant to be conservative. Pricing
- United States: The base monthly price for 2018 is known: $11 / month. It has since been increased by $2 to $13 / month, which prompted a quick jump in the stock price and, also, this article. I don't have any hard data behind my estimate of $25 / month in 2028, but the service is generally considered a good deal with its current offerings, and the value of the content will only improve, as it's being produced at a rate greater than anyone can actually watch it, and retains some value even as it ages.
- Western Europe + English-Speaking Developed: For reasons stated earlier, I expect the pricing and penetration rates for this group of countries to be just below those in the US. The international service should have the most greatest appeal in the culturally and linguistically similar countries, but still not as great as in its home market.
- Rest of World: Not surprisingly, subscription prices vary quite a bit across this group of countries. It's not possible to construct a perfect weighted average of current prices across these countries with publicly available data, as exact subscriber counts are not available by country other than the US. However, for a few data points, prices in 2018 were about $7 / month in India, $5 in Brazil, and $6 in Japan. I'm estimating the current average subscription price for this region to be roughly $5, and for it to increase a bit less than the average for groups #1 and #2 over the next 10 years.
Margin My estimates for margins are based on comps against the two most similar businesses I could find, which are Starz and HBO. Obviously there are some differences here: both Starz and HBO are typically sold as add-ons to cable packages, whereas Netflix is not bundled in that way, but fundamentally, all 3 produce and acquire content and charge a subscription fee for it. For the last full calendar year where data is available (2017) HBO (a segment of Time Warner) achieved $6,329 million in revenues and operating profits of $2,152 million, for an operating margin of 34%. Starz (a segment of Lions Gate Entertainment) achieved a remarkably similar operating margin of 33% in 2018, with segment revenues of $1,404 million and profit of $468 million. I am convinced there are some economies of scale in this business, and projecting Netflix in 2028 to be much larger than either HBO or Starz are today, so I’m quite comfortable with the estimate of operating margin at 35% for Netflix. I'm not concerned that Netflix's margins are currently much lower, as the business is not mature, and I believe the service to be currently underpriced. What does it all mean? So is Netflix a good buy here? It depends on your expectations and risk tolerance. My model estimates a market cap of about $402 billion at the end of 2028, for an annualized market cap growth rate of just about 10% - but wait, what about dilution? Actually, it hasn't been too bad; Netflix's shares outstanding have only grown by 3.3% over the last 5 years, as their management has mainly opted to tap the bond markets for the cash to build their content library rather than issuing shares. Assume the same rate of dilution and you get an annualized return of about 9.3%: not bad, but also maybe not what you were hoping for from a high-flying tech stock. And even if all the projections in this model turn out to be spot-on, I wouldn't expect a smooth ride for the stock price on the way to that 9.3% / year return. But is this model any good? The subscriber projections above, while somewhat rough, I think are fairly reasonable. For Netflix to nearly double their number of subscribers over the next 10 years does not sound extreme given the company’s growth track record to date. However, those subscriber counts will have them bumping up against the upper bound of the number of households with broadband access, at least in some countries. I am even fairly confident in the price / subscription, at least for the US: a subscription may not cost you exactly $25 per month in 2028, but I’d be willing to bet it’s somewhere between $20 and $30. I just don’t see them failing to increase prices by at least $0.70 per year over the next ten (9 and some change) years, but also expect that price increases of more than $2 per year would be seen as an unnecessary risk. What is much more difficult to forecast is what multiple the market will assign the company in 2028, which is another way of saying, how much growth will they be expected to achieve in the years after 2028? If you accept my numbers so far, that will have to come primarily from increasing subscription prices, and possibly achieving better margins. What could Netflix charge for a subscription in 2038? $40/month? $50/month? 0.14323 bitcoin / month? It would seem reasonable to use the price of a current cable bundle (anywhere from $40 - $100 depending on details) as an upper limit. However, I think that may be too conservative. Just as Uber isn't just a cheaper substitute for a taxi cab, Netflix isn't just a (currently) cheaper replacement for cable TV: it's actually much better than cable! You can watch whatever you want at any time, the user interface is great, and maybe the content is / will be even better than traditional television content because of all the viewer interaction data Netflix has accumulated. For these reasons I'm hesitant to put a ceiling on the monthly subscription price, and believe there is still at least potential upside for Netflix even at its current massive valuation. In any case, if you'd like to play around with the numbers for yourself, here's the model in a Google Sheet that you can copy. Enjoy!