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Investors long argued about whether Netflix (NASDAQ: NFLX) had a viable business model. Pouring vast sums into making shows while many users watched for free due to shared passwords did not necessarily sound like a brilliant way to make money. Last year, though, Netflix’s net income soared to a record $8.7bn. The Netflix stock price is up 76% over the past year alone.
Is it now overvalued?
I am not so sure: I see an argument for the stock price run to keep going. But, for now at least, the price does not sit easily with me. So although Netflix is on my watchlist of stocks to buy if the price gets down to the right level, I will not be investing for now.
Marginal profits and Netflix’s potentially brilliant business model
When I say I am not so sure that Netflix stock is overvalued, it helps first to understand the economic concept of marginal costs and profits.
Think about an oil company like Shell as an example. It has certain fixed costs, from pipelines to petrol stations. If it can spread those over higher sales volumes, the fixed cost per barrel sold will fall. But there are also marginal costs: each barrel sold involves some additional cost, such as transportation.
Compare that to Netflix. Its fixed costs, such as making blockbuster shows and promoting them, are sizeable. So, if it does not attract and retain enough subscribers (or advertisers) it could be heavily loss-making. Arguably, producing shows is a variable not fixed cost – fewer shows could be made, to save money. But that could affect the attractiveness of Netflix’s value proposition for viewers.
Meanwhile, Netflix’s marginal costs are very small. Flicking a virtual switch to send content down the wire to a new subscriber is close to costless. So, boosting subscriber numbers (or subscription costs) can add sizeable marginal profits for the business.
Boom times prove the model
That is why it can be hard to value Netflix stock.
The current price of 52 times earnings looks expensive. But those earnings can rise sharply, as we saw not only last year but over the past several years. On that basis, the prospective price-to-earnings ratio may look more attractive.
But if earnings fall while fixed costs remain high, that valuation could be pricey. At a time when many consumers in the US and elsewhere are looking to manage their household budgets closely, I see a risk of lower demand or a need to reduce pricing plans.
Revenues in the most recent quarter grew 16% year on year. Net income grew faster (46%), as did free cash flow (87%).
That neatly demonstrates my point above about the attractiveness of the business model when it comes to low marginal costs meaning higher revenues can feed disproportionately into profits. Nor is this just about boosting subscriber numbers: Netflix expects to double ad revenue this year.
The past few years have shown how well the firm’s business model can work during good times. But how well might it withstand a tighter economy?
If revenue keeps growing, Netflix stock could move even higher. But in a tighter economy I reckon subscriber numbers could fall, hurting revenue and profitability. So, at the current price, I will avoid Netflix stock for now.
