Often people try to justify a company's stock price by resorting to blanket qualitative arguments (for example, in the media space, one might hear that "Netflix (NASDAQ:NFLX) will 'own the future' in media distribution, thus valuation is irrelevant" or "Viacom's (NYSE:VIA) (NASDAQ:VIAB) business model is highly susceptible to cord-cutting, thus its stock should be avoided at any price", etc.). These kind of arguments are, unfortunately, quite imprecise and usually fail to incorporate a key determinant in the buy/sell decision process, namely valuation. It is easy to make a valid (and usually obvious) qualitative argument about a stock (anyone with a functioning brain can figure out that streaming TV is on the rise). However, a company that is clearly a buy at one price will always be an obvious sell at another (and vice versa). In our view a more appropriate method of answering the buy/sell question is through a bit of reverse engineering. Namely, one should begin with the current market valuation for a given company and then ask "Under what scenarios will Company X justify today's market or enterprise value?", as well as "Are these scenarios likely to occur or not?" If the answer is "yes" to the latter question, then the company is probably fairly valued or undervalued; if the answer is "no", then the company is probably overvalued.
Netflix versus Viacom
Consider Netflix and Viacom, for instance. With a market cap of almost $84 billion and an enterprise value (EV) of $87 billion, NFLX is currently beloved by investors, whereas with a market cap of $11.7 billion and an EV of $22.4 billion, VIAB is currently shunned by investors. NFLX's stock has skyrocketed over the past two years while VIAB's has plummeted. Here is the tale of the tape:
(Source: Google Finance)
Since December 2015, NFLX is up 48% while VIAB is down 43% (during the same period, the S&P has increased by 26%), signaling investors' love for the former and disdain for the latter. The reasons for this love/hate dynamic can be found in the qualitative arguments described above (per conventional investor wisdom, NFLX will "own the future" while VIAB appears to be "clearly dying"). However, what if investors were instead to ask "Under what scenarios will NFLX justify its current valuation?" and the same for Viacom? Well, let's see...
Netflix "What-If" Scenarios
First take NFLX, which can currently do no wrong in the eyes of the market. Let's assume that investors are correct, that NFLX will enjoy massive revenue and earnings growth far into the future, given its clear lead in streaming content over the Internet to its now 100+ million subscribers. Assume, for instance, that NFLX's earnings grow by a massive 80% from 2017's expected $1.25/share to $2.25/share in 2018, in line with analysts' current expectations; next assume NFLX's earnings continue to grow off of 2018's level by 30% per year through 2025, and then level out to 5% annual growth from 2026 through 2036. These are pretty aggressive earnings growth assumptions by any measure (under this scenario, NFLX's EPS would explode to $14/share by 2025). So what would be the value of this 2017-2036 earnings stream, if we discount it back to a net present value (via the "NPV" function in Excel) using a 5% discount rate? Approximately $66 billion, or $21 billion below the current enterprise value and $18 billion below the current market cap. In fact, in order to justify the market's view on NFLX, we would need to increase the 2019-2025 growth rate from 30% to 37%. So if one believes that NFLX can grow earnings 80% over the next year, 37% annually for 2019-2025 and 5% annually from 2025 to 2036, then the stock is fairly valued based upon the present value of its earnings over the next two decades.
But what happens if we dial back our NFLX growth assumptions just a bit? Let's say that instead of 80% growth in earnings over the next year, it turns out to be just 50%; and instead of 30% growth from 2019 to 2025, it is just 20%? Leaving the other assumptions the same (i.e., 5% EPS growth from 2026 to2036 and a 5% discount rate), we find that NFLX's 2017-2036 earnings stream would be worth just $33 billion, over $50 billion below both its market cap and enterprise value, indicating large expected downside for investors buying NFLX at today's market price. How about 40% growth for 2018 and 15% growth from 2019 to 2025? This still-impressive earnings stream would be worth just $24 billion in net present value. Looking at the numbers in the cold light of day, we see that, from today's "loved" valuation, in most reasonable growth scenarios, NFLX has either minimal upside or large expected downside. Not a bullish sign for those buying NFLX at current prices.
But wait, the bullish NFLX investor says, what about the terminal value for NFLX in 2036, shouldn't we also incorporate that into our valuation exercise? And, continues the NFLX bull, since NFLX is clearly going to "own the future" in media, shouldn't the terminal value be huge compared to any DCF amount for near- to mid-term earnings? First, we note that the vast majority of a company's value to investors depends on what happens in the next 20 years, rather than years 21+, due to the time value of money as well as the inherent uncertainty in predicting financial results decades into the future. Unfortunately, it is simply not possible today to accurately predict NFLX's financial performance in the year 2036, given how quickly the media landscape is changing. However, just to be safe, let's attempt to do some more reverse engineering in this respect. First, let's take the midpoint of the above-referenced $18 billion to $21 billion gap between NFLX's current market and enterprise value, respectively, on the one hand, and our base case DCF for its next 20 years of earnings, on the other hand (such midpoint being $19.5 billion), as the present value of NFLX's 2036 terminal value. Due to the inherent uncertainty in predicting events many years off, we will assign a conservative discount rate of 15% to this terminal value. Doing this, we find that the undiscounted 2036 terminal value for NFLX would be $319 billion (or $19.5 billion multiplied by 1.15^20). Assuming that NFLX in 2036 trades at 15X earnings, the company would be earning $21.3 billion per year ($319 billion divided by 15), or nearly $50/share (assuming zero net equity dilution going forward).
Is $319 billion a reasonable amount to assign to NFLX's 2036 terminal value? First, one should note that in its entire 20-year history from 1997 through Q3 2017, NFLX has generated a grand total of $1.55 billion in retained earnings, or about $78 million per year. Granted, in the first three quarters of 2017, net income increased to $373 million, so NFLX's financial performance is clearly on the uptrend. On the other hand, Disney (NYSE:DIS) and other deep-pocketed media companies are getting into the streaming game in a big way, meaning that a tsunami of competition is about to hit NFLX in the next few years. Moreover, the FTC is very likely to rescind the 2015 Net Neutrality rules, which could end up hurting NFLX if its customers are forced to pay higher amounts for access to high-speed bandwidth. Thus, we think it a bit of a stretch to believe that NFLX will inevitably become a $20+ billion per year income generator by 2036. But even if it does, we believe that this rosy outcome is already reflected in the stock price (assuming that one assigns an appropriately high discount factor, e.g., 15%, to NFLX's 2036 terminal value).
Viacom "What-If" Scenarios
Next take VIAB, which investors have heaved overboard with disdain lately. Let's assume that investors are correct, that VIAB will suffer for years from the cord-cutting effect. Assume, for instance, that VIAB's earnings eke out a minor gain from 2017's expected $3.71/share to $3.86/share in 2018, in line with analysts' current expectations, but then decline from 2018's level by 5% per year through 2025, before finally regaining 3% annual growth from 2026 through 2036. These fairly negative earnings assumptions produce a present value for VIAB's 2017-2036 earnings stream of approximately $16.7 billion, or $41.60/share, using a 5% discount rate (note that this assumes VIAB is able to maintain its current debt levels throughout such period). In order to shrink the present value of its future net income to equal VIAB's current market cap, the company's earnings stream would need to decline 14% (instead of 5%) annually from 2019 to 2025, before resuming 3% annual growth thereafter. This rate of decline would mean that VIAB would only be generating $1.34/share in earnings (or about $540 million in total net income) in the trough year of 2025, assuming no net share issuance or shrinkage between now and then. Is this latter scenario really the most likely outcome for an established media player with a lengthy history of significant profitability (totaling approximately $17 billion in retained earnings between January 1, 2005, and September 30, 2017, with an additional $8.42/share in dividends (or about $4 billion in total) paid out to shareholders during that period)? In any event, even if this scenario were to prevail, the company would still generate enough free cash (after payment of dividends) in the next seven years to pay down all but $1.4 billion of its current $9.7 billion in net debt. Thus, even assuming such a draconian decline in fortune, by 2025 net debt should be minimal and, at a 15X multiple, the stock price would still be over $20/share (and holders would have likely received significant dividends in the interim; note that VIAB currently pays a dividend of $0.80/year).
In allocating capital, if one protects against downside risk, the upside should take care of itself (or, as Warren Buffett has said in the past, rule #1 in investing is "Never lose money"; and rule #2 is "Don't forget rule #1"). Employing our reverse engineering method, we find that it would require an extremely serious and lengthy earnings decline to justify VIAB's low stock price today. While this could conceivably occur (anything is possible in a capitalist economy), we do not believe it is close to being the most likely outcome for the company. Our base case for VIAB is that earnings flatten out around current levels for several years before trending upwards again. Note that it would require just 2% annual earnings growth going forward (i.e., below the rate of inflation) to cause VIAB's 2017-2036 earnings stream to exceed the company's current enterprise value. And if VIAB could fairly quickly return to 10% earnings growth for the near- to mid-term (for example, through inclusion on various skinny bundles and/or other means of distribution, such as via telecom companies like Verizon (NYSE:VZ) or T-Mobile (NASDAQ:TMUS)), then the company's shares could be worth upwards of $60 to $90 (depending on how much debt the company permanently repays). Thus, looking at the numbers, we see that, in light of VIAB's current "hated" valuation, in most reasonable scenarios VIAB has either minimal downside or large expected upside, a bullish sign for those buying VIAB at today's prices.
While it is certainly easy to justify buying, holding or selling any given stock based on relatively simplistic qualitative statements or buzzwords, valuation should not be ignored. Why? Because a company cannot be worth more or less than the present value of its future net cash flows. Employing our reverse engineering methodology, we conclude that NFLX at its current valuation discounts an incredibly rosy future, which even if it comes to pass leaves minimal upside for investors buying or holding NFLX shares today. Conversely, even assuming seriously negative earnings declines for VIAB, we conclude that the low valuation assigned to it by investors discounts much of this negativity, leaving little additional downside for those buying or holding VIAB currently, and possibly significant potential upside should events play out more favorably for the company than investors now believe likely.
Disclosure: I am/we are long VIAB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We are also short NFLX.