As experts in valuation analysis, we think a rigorous discounted cash-flow process--combined with a relative value and technical assessment -- is the best way to make outsize profits and protect your equity portfolio from land mines, like Netflix (NFLX), for example. We think this methodology, our Valuentum Buying Index, is also responsible for the outperformance relative to the S&P of the portfolio in our Best Ideas Newsletter, as we rack up good calls--both on the long and short side.
But how could a DCF process have made or saved you big bucks in Netflix. Well, for starters, let's take a look at our valuation analysis on Netflix, published July 26 on Seeking Alpha, when the firm was trading over $250 per share ("Netflix's Valuation: Completely Absurd, Significantly Overvalued"):
In Neflix's case, using a discounted cash-flow model is the best tool for valuation as we think it enables investors to steer clear of emotional investing, thereby avoiding behavioral tendencies, which often end badly. We outline below our valuation summary for Netflix and offer a friendly challenge to readers to arrive at a fair value estimate via a DCF process (based on reasonable assumptions) that comes anywhere near Netflix's current stock price. Our DCF model valuation template can be found here (the template can be re-used to value any other operating firm you wish). We will post your results on Netflix and the defense of your assumptions, should they be reasonable, on our website for further debate on the valuation of this firm.
Under perhaps the best scenario imaginable -- one that sees revenue expansion over 30% for each of the next five years, on average, and earnings growth that reaches nearly $15 per share by the end of the fifth year in our projection period -- we can only reach a valuation of about $190 per share for Netflix ... and this is an optimistic stretch. Under this exceedingly optimistic scenario, we discount future free cash flows with a weighted average cost of capital assumption of 10%, which may be a touch light given the tremendous risks (upside and downside) related to the company. In other words, Netflix's valuation is a significant market outlier, and we can find little substantiation for its current stock price. We reveal our valuation summary below and think investors should attempt to value Netflix through a DCF model.
Interestingly, we received quite a bit of attention from our controversial call at the time on Netflix, but our subscribers were warned far in advance of the two month decline in the company's stock, which has left it wounded at around $130 per share. But how could you have made big bucks on this analysis. First, our subscribers could have opened up a large out-of-the-money put option on the name, which as of right now, would be a multi-bagger, at the very least. Or, for more conservative investors, they would have been adequately discouraged from dabbling in the company's shares. Either way, in-depth discounted cash-flow valuation analysis can only help your portfolio.
So, what do we think of Netflix now? Well, we are reiterating our optimistic $190 fair value estimate, but we wouldn't consider buying the firm unless it fell below $130 (our downside fair value in the table below) on improving technicals. This remains consistent with our methodology. In other words, it may be some time before we consider adding Netflix to our Best Ideas list.