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Shares of Netflix (NASDAQ:NFLX) have been on quite the roller coaster ride in the past year, after hitting a low $53, shares have rebounded to an astonishing $214 as of the time of this writing. This incredible rise has called into question for me the justification of such a move and this article will take a look at exactly what the market is pricing in for Netflix shares at the current market value.

In order to determine what Netflix's business is worth, we'll use a DCF-type analysis that requires some assumptions: 1) discount rate of 10% 2) perpetual growth rate of 4% 3) no dividends in the next five years and 4) earnings estimates from Yahoo! Finance. I have used what I consider to be reasonable estimates but all forecasting is subject to conjecture. You may disagree with some or all of my assumptions but this risk is inherent to forecasting.

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$1.32

$2.87

$3.45

$4.13

$4.96

x(1+Forecasted earnings growth)

117.50%

20.00%

20.00%

20.00%

20.00%

Forecasted earnings per share

$1.32

$2.87

$3.45

$4.13

$4.96

$5.95

Equity Book Value Forecasts

Equity book value at beginning of year

$13.40

$14.72

$17.59

$21.04

$25.17

$30.13

Earnings per share

$1.32

$2.87

$3.45

$4.13

$4.96

$5.95

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Equity book value at end of year

$13.40

$14.72

$17.59

$21.04

$25.17

$30.13

$36.08

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

$1.47

$1.76

$2.10

$2.52

$3.01

$3.61

Forecasted EPS

$1.32

$2.87

$3.45

$4.13

$4.96

$5.95

-Normal earnings

$1.47

$1.76

$2.10

$2.52

$3.01

$3.61

Abnormal earnings

-$0.15

$1.11

$1.34

$1.62

$1.95

$2.34

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

-$0.14

$0.92

$1.01

$1.10

$1.21

$1.32

Abnormal earnings in year +6

$1.32

Assumed long-term growth rate

4.00%

Value of terminal year

$34.38

Estimated share price

Sum of discounted AE over horizon

$5.42

+PV of terminal year AE

$19.39

PV of all AE

$24.82

+Current equity book value

$13.40

Estimated Current share price

$38.22

My model suggests Netflix is currently worth something like $38 per share. Before you start laughing uncontrollably, consider that the company, currently priced at $214, is only going to make $1 and change per share this year and less than $3 next year. Indeed, even if analysts' robust earnings forecasts of 20% growth in 2015-2018 hold up, Netflix will still only make $6 per share in 2018! I'm not sure about you, but I don't pay $36 today for $1 of earnings six years from now. Regardless, that is the price the market is currently assigning to Netflix, so the only rational conclusion to draw is that market participants don't believe the estimates. Indeed, with the price of shares so high, the estimates must be too low. Therefore, let's take a look at exactly what is being priced into shares at these stratospheric levels.

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$1.32

$2.87

$5.11

$9.10

$16.19

x(1+Forecasted earnings growth)

117.50%

78.00%

78.00%

78.00%

78.00%

Forecasted earnings per share

$1.32

$2.87

$5.11

$9.10

$16.19

$28.82

Equity Book Value Forecasts

Equity book value at beginning of year

$13.40

$14.72

$17.59

$22.70

$31.80

$47.99

Earnings per share

$1.32

$2.87

$5.11

$9.10

$16.19

$28.82

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Equity book value at end of year

$13.40

$14.72

$17.59

$22.70

$31.80

$47.99

$76.81

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

$1.47

$1.76

$2.27

$3.18

$4.80

$7.68

Forecasted EPS

$1.32

$2.87

$5.11

$9.10

$16.19

$28.82

-Normal earnings

$1.47

$1.76

$2.27

$3.18

$4.80

$7.68

Abnormal earnings

-$0.15

$1.11

$2.84

$5.92

$11.39

$21.14

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

-$0.14

$0.92

$2.13

$4.04

$7.07

$11.92

Abnormal earnings in year +6

$11.92

Assumed long-term growth rate

4.00%

Value of terminal year

$310.00

Estimated share price

Sum of discounted AE over horizon

$25.95

+PV of terminal year AE

$174.84

PV of all AE

$200.79

+Current equity book value

$13.40

Estimated Current share price

$214.19

And there you have it…78%+ earnings growth for the next 6 years! In order for NFLX shares to be justified at $214 and a 10% discount rate, you have to believe the company will produce nearly $30 of earnings by 2018 and continue to grow at 4% forever! I know it's tough, but please, contain your laughter.

Obviously, I consider this valuation to be patently absurd for any company but particularly in the case of Netflix. Given that the company has had some success in original content with House of Cards, it is now keen to continue to produce new content at massive costs. While I admire the company for attempting to defray the crippling content acquisition costs it faces in order to keep customers happy, original content is expensive to develop and there is no way of knowing what will work and what won't. What's next, will NFLX open a movie studio? I think what is happening is that management has realized the model is unsustainable without price increases (remember that?) or drastically decreased content costs. Since the intellectual property holders aren't going to give away their work out of the kindness of their hearts, NFLX is left to desperately create some content people actually want to watch. As I just said, I have my doubts about this strategy.

The point is this; even if you believe wholeheartedly in Netflix's ability to produce great content at a low enough price that it can actually bring in enough subscribers to pay for its development costs (which I don't), you have to pay 36 times 2018's lofty earnings estimates for the privilege. I just can't see any plausible scenario where this will turn out well for buyers of the stock today. My guess is, we will see NFLX back down at $50 before $300 again as there is simply no way this company can be worth $214 given its crappy business model. Buying a company based on its subscriber growth while ignoring the fact that it is struggling to make money is analogous to the tech bubble days. You basically have to believe the whole country will be NFLX subscribers in the next few years and that is not an assumption I'm willing to make. If NFLX continues to go up, it will do so without me.

Source: Netflix Is A 'House Of Cards'