As of this writing, the market capitalization of the world’s largest media conglomerate, The Walt Disney Company
This is despite the fact that Disney has four times as much revenue and twelve times as much net income as Netflix. This article takes a quantitative look at the question of whether this valuation is reasonable given their different expected growth rates.
Growth vs Value
During periods of strong economic performance, growth-oriented stocks historically have done quite well. On the other hand, during bear markets or recessions when valuation multiples deflate, value stocks tend to shine.
We’re at what might be “peak growth”, a record period where growth has outpaced value:
Chart Source: Capital Ideas
When it comes to growth stocks, it’s all about the story and the projections. When companies are growing their top line at 20% or more per year, investors are naturally willing to pay very high earnings multiples to get a piece of this growth, hoping that it will continue for a long time and trying to analyze whether it will.
When investors are right, and the company grows as fast or faster than they hoped for a long time, the annualized returns can be tremendous. But if their growth results are off by even a little bit in the wrong direction, a lot of money can be lost on a hyped-up stock. And during bull markets, forward estimates of growth stocks do tend to get inflated, which is why they outperform during good times but get weighed more severely in troubled times.
On the other hand, value investing is more about the numbers today with less emphasis on the future. With lower earnings multiples, book multiples, or sales multiples, and often higher dividend yields, value stocks don’t need to grow as quickly, and just need to keep doing what they’re doing gradually, and allocating capital well.
Achieving modest sales and earnings growth, maintaining a solid balance sheet and high returns on invested capital (ROIC), and using excess capital on dividends and share buybacks, is enough to give value stocks solid 8-12% annual returns or so. The results are more reliable, the downside risk is usually lower, but if bought at a low enough valuation can still result in double-digit annualized returns. Premium value stocks tend to hold up pretty well in troubled times because they have the earnings and cash flow to truly support their reasonable valuations.
Disney vs Netflix
Both Disney and Netflix are top stocks in the media industry, but they represent very different types of companies. Netflix is a classic disruptor growth stock, while Disney is firmly in the established value camp.
Disney owns Marvel, Star Wars, Pixar, Disney Animation Studios, Touchstone Pictures, ABC, ESPN, A&E, 30% of Hulu, and a host of theme parks, merchandising, music, and theater businesses. When the pending merger with Fox is completed, they will also own 20th Century Fox, National Geographic, and another 30% of Hulu.
Starting in 2019, Disney plans to launch their own Disney-branded streaming service at a lower price point than Netflix, with a focus on being kid-friendly, which will have hundreds of movies and thousands of episodes of TV shows. For example, after Captain Marvel leaves theaters in 2019, it will show on Disney’s streaming service instead of Netflix. The combination of this service, along with EPSN+ (the EPSN streaming service) and 60% of Hulu, Disney represents a significant streaming competitor.
Netflix, meanwhile runs a leaner operation. They have their DVD mailing business, their primary fast-growing streaming business, their studio production business, and minor assets like a small comic book company. Almost all the real money is in the streaming business.
Here are some rounded valuation, growth, and debt numbers for the two companies:
- Price-to-Earnings: 16
- Price-to-Sales: 2.9
- LT Debt-to-Tangible-Equity: 120%
- LT Debt-to-Income: 150%
- Dividend Yield: 1.5%
- Buyback Yield: 4%
- 5-Year Annual Revenue Growth Rate: 5%
- Net Profit Margin: 12-20% (varies)
- Employees: about 200,000
- Price-to-Earnings: 125
- Price-to-Sales: 10
- LT Debt-to-Tangible-Equity: 180%
- LT Debt-to-Income: 830%
- Dividend Yield: 0%
- Buyback Yield: 0%
- 5-Year Annual Revenue Growth Rate: 26%
- Net Profit Margin: 1-8% (varies)
- Employees: about 6,000
With Netflix’s outstanding growth rate, there’s no question that investors should pay much higher multiples for Netflix, but the question is how much higher.
Netflix is heavily reliant on growth. They have more than eight times as much long-term debt as they make in annual net profits, meaning at the current rate without growth it would take more than eight years to pay off their debt if they focused on it 100%. Of course, with Netflix’s rapid growth, they should quickly get this multiple down when their net income doubles, and then hopefully doubles again.
Disney is already in a pretty good place. Their networks are under cord-cutting pressure, but besides that, their film studios, media franchises, and other businesses are doing very well. Thanks to Disney’s large and top-quality collection of movies and shows, their family-friendly streaming service starting in 2019 is likely to do very well also, which should alleviate some of their legacy network issues. As it stands, Disney could pay off all their long-term debt in about a year-and-a-half if they focused 100% of net income on it, even without growth.
The Netflix Thought Experiment
We can form an optimistic projection about Netflix’s future growth rate to see what it may be worth in the future.
For starters, here is their historical subscriber growth:
Chart Source: Statistica
Based on this chart, about 45% of the 126 million households in the United States have Netflix. This is a relatively mature business at this point, with high market saturation. An investor would not pay an extremely high valuation for this level of growth.
Over the past several years, the average cost for Netflix to acquire a U.S. customer (marketing costs divided by new subscribers) increased from $40 to about $140:
Chart Source: Timothy Green
At a little over $10/month for the average subscription plan, that means Netflix pays over a year’s worth of subscription fees to acquire a new customer. And then there’s all the money it takes to license or produce the content, and the money to maintain the cloud streaming service, and overhead. A customer has to subscribe for several years for Netflix to make their money back.
Internationally, things look better. That’s where their real growth is. Their international service is newer and less saturated by far, so customer acquisition costs are still steady at between $40 and $50 per customer.
However, Netflix has been issuing a lot of debt and maintaining several consecutive years of negative free cash flow to expand internationally and improve their content portfolio.
Chart Source: Bloomberg
As it currently stands, Netflix’s business isn’t sustainable. If international growth were to slow down, Netflix would likely have significant trouble becoming profitable.
However, the eventual goal is for expenditures to grow more slowly than subscriber revenue. Netflix’s programming and expansion costs will likely level out as their content portfolio matures, while their international subscriber revenue looks set to keep increasing. Depending on how far that goes, Netflix’s profits could skyrocket.
Here’s a thought experiment. The international market is much, much larger than the U.S. domestic market. Suppose Netflix reaches 65 million subscribers in the United States, and 5x as much (325 million) internationally. With 390 million subscribers paying $12/month for service at that future time, that’s $56 billion in annual revenue (a little less than Disney has today).
How long could this take? Well, Netflix approximately doubled subscribers in three years from 2015 to 2018.
Getting to 390 million subscribers means doubling its current 130 million base and then increasing by another 50%. As the company grows, subscriber growth slows. Let’s say it takes 3 years to double to 260 million, and 3 more years to increase 50% more to 390 million. So by 2024, Netflix might have 390 million subscribers, with most being outside the United States.
At the current net profit margin of 7% (albeit with massively negative free cash flow), $56 billion in revenue would generate $3.9 billion in annual profit for Netflix. However, let’s assume the company can flatten out its annual capital expenditures on content and boost the net profit margin to 20% with positive free cash flows. At $56 billion in revenue and strong 20% net margins, that would be $11.2 billion in annual net income. Again, that’s roughly where Disney is today in terms of net income.
At that point six years from now, Netflix growth may be slowing, and we’d expect a lower valuation. Would 25x earnings be appropriate? That would place the market capitalization at $280 billion, which would be about a 11-12% annual return rate for the stock from today’s price. Valuation depends what growth rates still look like at that point, and whether they’ve entered another industry or remained focus on their simple business model.
That’s a very optimistic outlook, including a tripling of overall subscribers and a near-tripling of net profit margins over a six year period.
Over these hypothetical six years, Disney will have long-since launched their branded streaming service, and continued to invest in theme parks, movie studios, and possible acquisitions. In addition, Disney buys back about 4% net of its shares per year, meaning earnings-per-share tends to increase about 400 basis points more per year than company-wide net income. Disney also pays a 1.5% dividend yield, so the total shareholder yield is about 5.5% on top of any growth in revenue and net income they achieve. They need to increase their net income by about 5% per year to achieve 11-12% investor returns per year.
Netflix is currently priced as though it will be larger than Disney within a decade. This isn’t an unwarranted possibility if Netflix’s international streaming business keeps growing at the rate it is, their profit margins improve, and their free cash flow turns positive after this period of high investment.
However, with existing streaming competition from Amazon, and Disney ramping up their streaming efforts in 2018 and 2019, and AT&T
When it comes to investing in your IRA or taxable account, what ultimately matters is how the company performs and whether you bought at a reasonable price. At this point, while I’m optimistic about Netflix’s growth prospects as a company, the current price doesn’t provide as much of a margin of safety as I’d like. It’s not unreasonable or euphoric, but there is a lot of positivity baked in.
After a long period where growth stocks have outpaced value stocks, I’m more inclined towards value stocks in this late-cycle environment.
However, I’m certainly not shorting Netflix, and if we find ourselves in a big bear market or recession with valuations reduced for growth stocks, it’s possible that Netflix will be a bargain in the future and represent a better risk/reward profile to invest in.