If a value goes up, it is because the market “knows something”, some say: unfortunately, in certain cases – like GameStop for example – the market… does not know anything. And that hurts.
We are currently identifying a more moderate version of the GameStop storyline at Netflix, which has a market cap of $ 240bn.
Basically, the market estimates that the present value of future free cash flow, over the future life of the business, is $ 240 billion.
Here is some subsidiary data:
The discount rate used to calculate this real value is roughly the annual rate of return a shareholder hopes to achieve in the future. Presumably, most people are hoping for a high return on Netflix stock: let’s say it’s 10% per annum. If so, Netflix’s future cash flow should be discounted to 10%.
The most distant cash flows are therefore not worth much today. For example, a cash flow of $ 1,000 in 2041, discounted to 10%, is only worth $ 148.64 today.
It is often said that valuations of large-cap growth stocks are justified by low interest rates. Is. Say we lower the discount rate from 10% to 3%, for the 2041 cash flow. Its present value climbs to $ 553.68.
But we must not forget one thing …
By dropping the discount rate to 3%, we’re also saying that the stock’s annual rate of return, going forward, will be 3%. With a yield this low, it doesn’t sound like a good deal, for a company with the maturity of Netflix that has yet to generate significant cash flow.
A tough challenge
In order for the long-term holder of Netflix shares to earn a decent return from today’s price, the company would need to grow its subscriber numbers for many years to come and retain its loyalty. existing clientele, while not spending disproportionately on content (which implies a reduced number of “flops”).
Otherwise, the company will not offer the cash flow expected at a valuation of $ 240 billion.
It’s going to be a tough challenge, as the major groups that own Hollywood Studios (including Disney, NBC Universal, AT&T and Viacom) go all out in streaming services. All of them intend to attract spectators willing to pay around $ 15 per month.
These large groups attract viewers by advertising the next “blockbuster” to be released on their streaming services. This attracts “zappers” for a month or two, a small percentage of whom remain.
There is so much choice in the streaming world that it’s likely to produce a strong correlation between spending on content and audience retention.
If so, estimates of a future windfall of cash available at Netflix are likely to disappoint. Netflix will have to continue to spend heavily on its content.
Also, consider the actual budget limits for a household that spends an average of $ 50 to $ 70 per month, on three or four streaming services, in addition to the approximately $ 100 on the internet.
It would be exactly like the old cable packages… but less predictable than cable because the customer can cancel a streaming subscription by pressing a few buttons on their phone.
The problem, with the FAANG …
When publishing its results in January, Netflix implied that the company was getting closer to self-financing (that is, customers, and not the junk bond market, will be able to fund content. , in the future).
Therefore, Netflix is considering a share buyback program. Here’s the fun part: With a market cap of $ 240bn, the stock’s price / free cash flow ratio, in 2020, is a meager 0.80%. This is how Netflix would have performed in 2020 if the company had decided to distribute all of its free cash for 2020 as a dividend.
Therein lies the problem, with these FAANG (Facebook, Apple, Amazon, Netflix, Google) market capitalizations amounting to several hundreds of trillions of dollars: the free cash flow that they can distribute to shareholders is just a drop in the ocean, compared to their colossal capitalizations.
“No worries” say those who are bullish on the FAANG. “All this cash will arrive in future years. Wait and you will see! “
The bulls are so convinced that “future exercises” will play out in such a way that they are prepared to pay accordingly today.
Yet competition, economic weakness, regulatory risks, rising corporate taxes, rising interest rates, and technological “disruptions” could all dampen FAANG’s future free cash flow.
“The market needs to know something to push the FAANGs up to this point,” the bulls might retort.
But as the GameStop bubble shows, sometimes the market doesn’t know anything. Or, worse yet, sometimes the market moves in a very destructive way, and wastes scarce capital.
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