Pages

  • Home
  • About
  • Earnings Calendar
  • Economic Calendar
  • Subscribe
  • Contact

Great Companies Make Great Investments... Not Always

We wrote an article on Netflix (NFLX) a month or so back and people responded vehemently saying that we were stupid; we were idiots; this time was different; Netflix is the greatest company ever; and Netflix will take over the world. (Perhaps the last few are hyperbole, but you get the point.)

We weren't even arguing that Netflix is a bad company or that it has a cloudy future ahead of it. We were just saying that no company has an infinite price and that maybe Netflix's valuation has surpassed its prospects - even if those prospects are no rain and all sunshine. It would be the first time in history for a company, but - so be it. Netflix will never lose a dime; never become a victim of the competitive forces of capitalism; or never become obsolete in this rapidly evolving technological world. OK... so it will exist into perpetuity. Well, we actually have a formula to value that.

Sometimes even great companies aren't worth what you have to pay for them.

Netflix generated… not zero… but a negative $128 million in free cash flow in 2014. The negative free cash flow isn’t necessarily a bad sign as the company is trying to grow, but it’s also true that free cash flow in the red over extended periods of time usually leads to trouble and at worst – bankruptcy. Companies that take on such a strategy have to have a perception of future viability and access to capital to plug the cash flow holes. As seen in the Financial Crisis, funding sources can dry up for even the best companies.

Thus, at some point, Netflix has to turn cash flow positive to be a viable company. Over the last twelve months, the company has burned even more cash than it generated, showing a negative $543 million in free cash flow. But, ignore that. Let's take its best year of free cash flow. In 2009, the company generated $279 million of free cash flow. Let's say that the company will grow by 5% in perpetuity, about the rate that the U.S. economy grows at when it's at full steam in lieu of the current 2% or 3%. Anything higher than 5% would really be wishful thinking. Maybe Netflix grows faster in its everlasting existence, but you have to cut the insanity off somewhere.



Now the perpetuity formula alluded to earlier. Perhaps the easiest formula in finance: V = CF/(r – g) where V is the value; CF is the cash flow next year; r is the required return of the investor; and g is the rate that CF will grow in perpetuity. The required return used by finance professionals would most likely be around 12%, but let’s once again be generous to Netflix and cut that rate in half to 6%. Now we have all the parameters. Divide CF by (r – g) and BOOM! You have a valuation. Not difficult at all. Let’s do it:

V = $279,000,000/(6% – 5%) = $27,900,000,000

Wow! That’s $27.9 billion… with a B! Let’s just call it $28 billion. Fine with me.

Netflix’s market capitalization? $40 billion. Let’s ignore investing by the company and just consider the operating cash flow, which was also at its highest point in 2009 at $325 million. This is if the company never bought another server, building, or other hard asset again. Let’s get a valuation with the same formula:

V = $325,000,000/(6% – 5%) = $32,500,000,000

We’re still short of the actual valuation of Netflix at $40 billion. But we were so generous! It’s easy to see that maybe things are a little ahead of themselves. Take a step back and take a deep breath. As said earlier, Netflix may very well be a great company and do extremely well over time. But taking over the world? Probably not. As an investor, you have to divorce the underlying company’s prospects and its valuation. The two do not always mirror each other. This is why Warren Buffett says that he would rather buy a great company at a fair price than a fair company at a great price.

No company or stock is worth infinity. Be reasonable when you invest. The calculations here for Netflix just lend some perspective to the company’s valuation and if it makes sense given all the generous parameters. Remember: price is what you pay and value is what you get.

- Andrew Sebastian

Get New Article Updates:



More from ADS Insights:

Recent Posts Widget