I Had No Idea Netflix Was THIS Overpriced

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Aug 26, 2015
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I, like many others, hope to find bargains given the recent market selloff. Netflix (NFLX, Financial) offers a good service, and it’s a great company. There were headlines that the stock had fallen a sizable percentage these last few days. Curious, I went to see if there was an opportunity. When I pulled up the company’s financial metrics, I was shocked to see its valuation. NFLX is trading at a PE of over 200!

Let’s stop and think about what the PE ratio is. It’s the price per share of the company divided by the earnings per share. If you flip the denominator and numerator around, you get EPS divided by price or earnings yield. Theoretically, a stock with a constant PE of 10 gives you an earnings yield of 10% in perpetuity. With Netflix at a PE of 200, it means you pay $200 for $1 of EPS or an earnings yield of 0.5%. That’s horrible.

Netflix bulls will say the company is growing like gangbusters. I cannot disagree that Netflix is growing very rapidly, but let’s try to rationalize this. Let’s go with the assumption that all companies stop growing at some point and a PE of 10 is reasonable for a stable, non-growth company. Netflix is trading at $101.53/share which means at some point the company needs to get EPS up to $10.15 to justify today’s price. FY2014 EPS was $0.62. From 2001 to 2014, NFLX grew earnings at a CAGR of 45%. I start at 2001 because NFLX was losing money prior to that time. At 45% CAGR, it will take over seven years to reach $10 in EPS. Using 45% as the growth rate is being overly generous as it’s not likely NFLX will keep the torrid pace of the last 13 years. If I lower the growth rate to 30%, then it will take over 10 years to reach $10 EPS.

Looking at number of members

Per the latest 10Q, net income was $26,335K. U.S. memberships (customers) were 42.3M and international was 23.25M for a total of $65.5M. That means net income per member comes out to $0.40 per the quarter and if we extrapolate would be $1.60 per year.

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How much membership growth would NFLX need to justify its current price? I’ll be generous and give the company a PE of 45 which would make $2.26 the necessary EPS vs. trailing EPS of $0.62.

Target EPS at PE of 45 $2.26
Shares Outstanding 425,340,000
Target Net Income 961,268,400
Net Income per member / Year $1.60
Target member base 600,792,750

Assuming the same margin %, NFLX would need to grow membership to over 600M or 9.1X its current membership. When faced with these large numbers, it makes sense to look at total addressable market. Here are some reference points.

  • For the USA: According to Nielsen’s 2014 Advance National TV Household Universe Estimate (UE), there are 115.6 million TV homes in the U.S., up 1.2% from the 2012-2013 estimate of 114.2 million.

    For the USA: According to Nielsen’s 2014 Advance National TV Household Universe Estimate (UE), there are 115.6 million TV homes in the U.S., up 1.2% from the 2012-2013 estimate of 114.2 million.

  • For Europe per Statista: In 2012, there were 168.78 million pay TV households in the region.

    For Europe per Statista: In 2012, there were 168.78 million pay TV households in the region.

NFLX would need to get 100% of the user base in the U.S. and Europe and then pick up an additional 316 million users to get to a PE of 45. It’s at a TTM PE of 218! Bulls will point to China. Those people don’t understand China. Setting up shop in China is a completely different story than Europe. Just ask Google (GOOG, Financial)(GOOGL, Financial) and Amazon (AMZN, Financial) or any U.S.-based company doing business in China.

Conclusion

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I can't understand how Netflix reached its current price. Current valuation isn’t even the craziest part. The average Wall Street analyst thinks Netflix should be priced higher with one analyst with a price target of $175! Netflix is an example of why I never short stocks. When a stock strays from fundamentals, there's no telling how high it will go. I’m curious to hear other people’s opinions.