It’s not strictly a technology stock, but Netflix Inc. (NFLX.O) is flirting with valuations that would fit in with its nearby Silicon Valley neighbors. Are the numbers justified? We turn on the spotlights and sharpen focus on this provider of movies and TV shows.
There are two ways of explaining the gap between tech company valuation models and market valuations. As tech companies create new business models and capture the attention of the investment community, the first explanation is that the new business model is sufficiently different, and the growth profile so robust, that traditional valuation models do not accurately value the company. The alternative explanation, requiring less of a leap of faith, is that over-hyped investors build in such a premium for high growth companies that explanations such as the former are required.
Of course the explanations are not mutually exclusive – it’s likely that Silicon Valley and its offshoots are changing traditional business models in certain industries – but also that the market is over-reacting to this phenomena with valuations that already imply considerable commercial success.
One area where the business model continues to evolve is in media content. Netflix CEO Reed Hastings has demonstrated a continued willingness to recreate his business model and destroy existing revenue streams. In many ways his approach is reminiscent of Apple Corp.’s Steve Jobs release of the iPhone, immediately relegating his best-selling iPod to the obsolescence department.
Source: Thomson Reuters Eikon/StarMine
Checking metrics
So what does a NFLX growth profile look like? Let’s look at a few different metrics, all available via Eikon:
• Sell Side Long-term growth forecast
• StarMine Smart Growth (5-year CAGR)
• StarMine market implied growth
Source: Thomson Reuters Eikon/StarMine
Bullish numbers
Firstly, the sellside has a mean long term annual growth forecast of 22.5%. This is an unadjusted estimate of the growth rate beyond the analysts’ explicit forecasting horizon – so normally three years or later for U.S. companies. Twenty-two percent is a pretty bullish number but over the shorter term, the StarMine growth rate is even higher, with the 5-year CAGR being 66.5%. This growth rate is adjusted, with the forecasts adjusted to remove much of the over-exuberance evident in longer term forecasts. In order to make clear we’re not beating up on the sell side, I would note that academic research has found equal if not greater over-optimism inherent in buyside forecasts.
Source: Thomson Reuters Eikon/StarMine
Pondering multiples
Unfortunately, the bad news is that the current price reflects a much higher expectation than 66.5% — in fact, the market is implying a 5-year CAGR of 121.8%. This is where the commentary around valuation comes into play. Does one assume that the market believes traditional valuation approaches don’t apply in the new technology space, or does one assume that easy money, enthusiasm for technology and a short memory have all conspired to move many companies to a multiple of fair value? There’s no way to answer that, but it’s a crucial question to ponder.
It’s worth remembering what the world’s most famous investor, Warren Buffett, said after significant underperformance at the height of the 1990s tech boom (1999 Berkshire Hathaway Letter to Shareholders):
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries — and seem to have their claims validated by the behavior of the stock market — we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality.
Today, many of Silicon Valley’s trends remind me of the turn of the 21st century (for instance, IPOs are returning to favor) and social media has replaced networking as the new new thing. Silicon Valley property couldn’t be hotter and entrepreneurs are buying newspapers and numerous other trappings of success — or hubris.
For those who believe in the positive future of technology, just remember that radio, television, networking, airlines, railroads and dozens of other new technologies all eventually changed the world in which we lived, yet their industries impoverished as many investors as they enriched. Technological innovation can be the path to riches for those who identify trends at an early point – but with even taxi drivers talking about their tech holdings – it’s déjà vu all over again.
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