Netflix: Will it fall like a House of Cards?

By: Arjun Goyal

All eyes are currently on stock’s meteoric rise. But how long will it last?

Perhaps the only thing more volatile than the weather in New York this year has been the stock market. With the Vix–a measure of expected volatility of the stock market–rising to as much as 37 and the Dow Jones crashing to less than 24,000, Wall Street’s boat has definitely been rocked quite violently. However, one stock on the market has been doing quite well, barring certain rare blips, even in this time of turmoil. Netflix.

The online media and entertainment company’s stock has been rising consistently not just this past year, but in the past few years. In fact, it has given more than a 1000% return in the past 5 years, and almost a 25,000% return since its IPO in 2002.

However, in a world of high margin companies like those in energy or emerging technology, or those in financial services, what makes an online entertainment company like Netflix gain so much traction in the market and get such consistent gains, especially in the past year? To examine this, we need to first see what determines stock prices on the market.

Traditional theory on stock prices

The efficient market theory in finance states that the price of a stock represents the true value of the company at the time, since all information about the company is incorporated into the price of the stock. While this may make sense logically, there is certain empirical evidence that brings the validity of the theory into question. In addition to the components of stock prices, the theory implies that it is impossible to beat the market using available information, since the price of stock has already incorporated all information in it. If it were impossible to beat the market consistently using all available information, then large investment firms and funds would not be able to beat the market consistently like they have for so long. This is one of the primary reasons why modern day investors reject the efficient market hypothesis, and why using it to find the rationale behind Netflix’s meteoric rise.

Theory of Value Investing

The alternate theory was formulated by famed investor Benjamin Graham. According to him, prospective investments should be chosen by assessing and analyzing the financials and fundamentals of the company, such as the earnings report, cash flow statement, balance sheet etc. These companies should be invested in if the stock price is undervalued so that returns can be made when the company starts to show its value and the stock price rises to correct itself.

Modern investors like Warren Buffett follow this method of investing, and if done correctly, it has, more often than not, yielded above average returns on investments.

Applying this to Netflix

The theory of value investing seems to be the body of knowledge that should most closely reveal the reason to Netflix’s recent stock price rise. However, as I see the fundamentals of the company (financial and market data that shed light on value), I see quite a few issues with the upward trend of its stock price being in line with the theories of value investing.

2017 was good year for Netflix, since it earned upwards of $550m in profit after tax. However, they earned this amount on a revenue of $11.69b, giving them a profit margin of approximately 5%. In vacuum these numbers seem arbitrary, but we can give them some context by comparing them with the earnings data of Time Warner, a competitor. In 2017, TWC had a net income of $5.2b with a revenue of $31.27b, giving them a profit margin of 16.6%. Even with these basic numbers, TWC has only grown 65% over the past 5 years compared to Netflix’s 1000%. There are more worrying signs for Netflix.

Netflix has an EPS (earnings per share; it represents the annual return on each share) of just $0.4 compared to TWC’s EPS of $2.66. For the financial nerds out there, this gives them a P/E ratio of 210 ( having a P/E in triple digits is a sure fire sign of overvaluation). Netflix also has a negative free cash flow, and does not give out dividends. On top of that, with the Disney-Fox deal, they are likely to face stiffer competition in the online entertainment space. All of this happened to Netflix in a good year. With this information in mind, it seems difficult to find any rational explanation to why Netflix’s stock would continue to go up the way that it has in the recent past.

A wave of hope

By this point, I think we can all agree that Netflix is heavily overvalued based on its current performance, even in light of its prolific performance in 2017. I talked to my finance professor about this, and even without closely looking at the financials of Netflix, he could say that the market valuation of the Netflix stock was ridiculous, and the price was not exclusively based on the current performance of the company. Aswath Damodaran, a professor at NYU Stern and one of the leading experts in company valuations, has also projected that Netflix is overvalued by over 40% (in 2016 when he conducted the analysis).

What makes Netflix such a gainer? Hope. Investors and analysts have high hopes for the entertainment company in the future. While it may not be doing as well as the price may suggest, Netflix’s price represents the expectations investors have in what the company is going to be in the future. And this expectation was built by its growing popularity and is being encouraged by its bold expansion moves.

Netflix posted significant growth in international subscribers in the past few years, and has worked tirelessly to add to its large list of TV and movie offerings. Most notably, it has invested a large chunks of its revenue in developing its own content. And I can say with certainty that a lot of this content is really, really good (House of Cards, The Crown, Orange is the New Black to name a few). With all these efforts, it has been able to stand its ground against its competitors like Hulu and Amazon Prime Video. TechCrunch estimates that by April 2017, Netflix had captured 75% of the online streaming market. While many users (including myself) have subscriptions to multiple services, Netflix is still seen ahead of the pack when compared to Hulu (17%) and Amazon Prime (33%).

All of this translates to the fact that Netflix is trying to be more than just online streaming service, and investors see that. The price rise of Netflix represents investors’ hopes that Netflix will soon be a heavyweight in the entertainment industry, along with Fox, Disney and Time Warner. Its current state is seen as temporary and a stepping stone to reach its true potential.

Will it last?

Analysts and experts have stated that Netflix will continue to rise this year. UBS and Macquarie have increased their target price estimations in the wake of its January performance. But how long will this rapid rise go on?

The truth is that there is no way to know. It is highly unlikely that the stock will continue going up at this rate in the long term. Many say that it is imminent to cool off and correct itself to a more realistic valuation. My personal opinion is that this rise will continue for a while more, simply because Netflix has momentum on its side. However, it seems unlikely to me that Netflix can sustain itself at this valuation for a long period of time. I feel like there will come a time where it will begin to fall. While there may not be a crash (like how the Dow Jones had to correct itself this past month), there are certain factors that I feel will lead to the cool off.

I think a large part of Netflix’s rise has been a self-fulfilling prophecy of speculation by analysts. They expect the stock price to rise and buy more, leading to an increased demand and hence an increased price; this thought process continues to repeat itself. I don’t want to explicitly call this a bubble, but it seems to me that it has similar characteristics. Additionally, there is no saying what may hit the entertainment industry next. Netflix has ridden the Me Too wave in Hollywood surprisingly well, partially by managing to distance itself from Kevin Spacey (a star on its hit show House of Cards). But it’s impossible to guess what may happen next that may affect the prospects of the company. I also think that there will be a point where the addition of new subscribers will begin to hit a slump, and so will the quality of its content.

By no means is any of this stock picking advice, since I am no expert on either stocks or the entertainment industry, even though I wish I was. It just seems fascinating to see how a company that started in 1997 as a DVD sales and rentals business has turned into our go-to late night or binge-watching resources. We will just have to wait and see where its stock goes in the future.

Works Cited

Staff, I. (2016, September 28). Efficient Market Hypothesis – EMH. Retrieved March 05, 2018, from https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

Reiff, N. (2017, May 04). The Greatest Investors: Benjamin Graham. Retrieved March 05, 2018, from https://www.investopedia.com/university/greatest/benjamingraham.asp

Kennon, J. Learn How Stock Prices Are Determined. Retrieved March 05, 2018, from https://www.thebalance.com/how-stock-prices-are-determined-358144

Time Warner Quarterly Earnings. Retrieved March 05, 2018, from http://ir.timewarner.com/phoenix.zhtml?c=70972&p=quarterlyearnings

Damodaran, A. Musings on Markets. Retrieved March 05, 2018, from http://aswathdamodaran.blogspot.com/2016/02/the-disruptive-duo-amazon-and-netflix.html

Franck, T. (2018, March 05). Already up 60% this year, a pair of analysts see Netflix rising even higher. Retrieved March 05, 2018, from https://www.cnbc.com/2018/03/05/already-up-60-percent-this-year-a-pair-of-analysts-see-netflix-rising-even-higher.html

Perez, S. (2017, April 10). Netflix reaches 75% of US streaming service viewers, but YouTube is catching up. Retrieved March 05, 2018, from https://techcrunch.com/2017/04/10/netflix-reaches-75-of-u-s-streaming-service-viewers-but-youtube-is-catching-up/

NFLX Income Statement. Retrieved March 05, 2018, from https://www.nasdaq.com/symbol/nflx/financials?query=income-statement

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