- November 1, 2022
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Link Between Business Model And Valuation
The focus of any company is to either gain a competitive advantage or maintain their competitive advantage. A company with a competitive advantage over its rivals generates higher shareholder returns. In addition, employees often like to work in these organizations, and customers are happy with their services. Thus, investors who want to invest their capital must want to evaluate a firm’s competitive advantage. Unfortunately, accounting numbers focusing on gimmicks like share buybacks to boost near-term earnings per share do not help investors identify competitive advantage. Accounting numbers treat intangible investments as expenses, mismatch costs with revenues in the case of restructuring charges and ignore the opportunity cost of investment. Thus, investors must understand the strategic assets of the company and its business model before valuing a business. This post provides my insights on the link between business models and valuation. I take the example of Netflix to substantiate my case.
When valuing any firm, we must focus on the following:
- Understand strategic assets that generate value. For a biotech company, patents and drug approval are strategic assets. For a platform company, it is the new subscribers. For a service company, it is the new customers added and the churn rate.
- Develop insights on the firm’s investments to develop strategic assets. However, accounting often treats these investments as expenses, especially for intangible investments like R&D and customer acquisition costs.
- Understand the steps firms take to preserve their competitive advantage against the threat of competition and disruption. For instance, if Apple reduces its advertising spending to improve short-term earnings, it is not good news because it will lose its competitive advantage over the longer term. However, if the investments do not generate excess returns, then reducing spend adds value.
- The firm’s efficiency in monetizing its strategic assets relative to its competition helps investors understand the returns on investments and decides the supply of the firm’s external capital.
- Finally, the discounted cash flow model quantifies the firm’s value creation and ability to create, preserve and deploy strategic assets.
In the chart below, I provide strategic assets for industries ranging from pharma to Oil & Gas to platform companies to media firms.
Netflix Business Model
Netflix was part of the elite FAANG group that generated substantial shareholder returns. From 2003-2009, Netflix’s market cap appreciated by 33.36% CAGR; from 2010 to 2017, its price appreciated by 50% CAGR. Netflix’s rise is its subscriber base and ability to scale up as it gets larger. In turn, these subscribers helped the firm increase its revenues over time.
Netflix disrupted the streaming business, and other players like Disney and Amazon tried adapting to its streaming model. Thus, Netflix’s business model hinges on the following value drivers:
- Content spending: Netflix spends billions on content apart from licensing to develop its original shows. For instance, its movie Darlings was the most watched non-English content in 2022. Netflix amortizes the content spending on its income statement and cash spent on content in its cash flows. For instance, in Q3 2022, Netflix expensed $4.7 billion on content in its income statement but added $4.58 billion on its cash flow statement. Thus, Netflix’s profits and cash flows must converge, and Netflix’s CAPEX expenditures are mostly amortization expenses.
- Netflix wants to control its content costs and have less exposure to movie studio price hikes. So its recommendation algorithm helps understand its subscriber taste and produces content that caters to its subscribers.
- Netflix introduces stickiness to its business models by gaining new subscribers and retaining existing subscribers despite increasing subscription prices. Though last year, Netflix faced churn due to price increases, overall, it gained revenues.
- Netflix manages the investor’s expectations by focusing on subscriber numbers. In all its earnings calls, the one number that analysts focus on is new subscriber additions and churn rates. When the firm increases the new subscriber additions at the expense of negative cash flows, its stock price always increases.
- Netflix has gone global to focus on new subscriber additions. Its focus on the Asia market and its success in India will determine Netflix’s stock price movement in the future.
To summarize, Netflix’s business model is to spend on content to attract new subscribers and then monetize those subscribers to add value. Since Netflix treats the content costs as fixed, any decline in subscriber additions will erode its value which is different from Spotify, where content costs are variable. Thus, we see Netflix stock prices plummet whenever it reports a decline in its total subscribers.
Valuing Netflix Using DCF Model
As we understand Netflix’s business model and the key metric that drives its share price, I try to value it using the DCF model. As subscriber numbers form the crux of Netlix’s valuation story, I value Netflix with the subscriber-based approach.
Following are the trailing twelve months’ revenues and subscriber numbers for Netflix.
Netflix is trying to increase its subscriber base in Asia, although its revenue per subscriber in Asia has declined in 2022 against 2021. However, Netflix is evident with its strategy in Asia that Indians are price sensitive. Thus any success in gaining market share in India must come at the expense of price.
When I break up Netflix expenses for 2022, they are as follows:
Unfortunately, one of the flaws in Netflix’s accounting statements is that it does not allocate the expenses to existing and new subscribers. Thus, I have assumed the following:
- First, I treat the G&A expenses as the cost of servicing existing subscribers.
- Second, I treat the Marketing expenses as the cost of acquiring new subscribers.
- I allocate 20% of content costs as the cost of servicing existing subscribers and the remaining 80% to corporate expenses. I have included the technology costs in the corporate expenses.
Valuing an Existing Subscriber
- Netflix’s success is its customer stickiness reflected by low churn rates. As of 2022, Netflix’s renewal rate is 95%, and with its quality content, I assume it will continue at 95%. The current monthly membership cost is $11.85, translating to an annual cost of $142. I assume the life of the Netflix subscriber is ten years. With its quality content and proprietary recommendation engine, Netflix can afford to increase membership fees by 5% annually, giving it pricing power.
- Netflix’s cost of servicing its existing subscriber will grow annually at 2%.
- Netflix’s effective tax rate is 13% and will converge to 27% at a steady state.
Cost of Capital for Netflix
- Netflix has $16,432 million in debt with $718 million as interest expense. Its effective interest rate is 4.1%.
- Netflix derives 44% of its revenues from North America, 32% from Europe, 13% from Asia and 11% from LATAM. Thus, i calculate the weighted equity risk premium at 4.46% assigning revenues as weights.
- Netflix’s unlevered beta is 0.96, and with an 11% Debt to capital ratio and 27% marginal tax, the levered beta for Netflix is 1.05.
- Netflix’s risk-free rate is 4.06%, a ten-year US treasury bond rate.
When i input the above numbers, i derive the cost of capital for Netflix at 8.18%.
For arriving at Cost/existing subscribers, i use the G&A expenses for Netflix and 20% of the content costs and divide by total subscribers.
G&A expenses for Netflix = 5% of revenues = $1,452 million.
Allocating 20% of content costs gives 20% off $18791 = $3.75 billion.
Cost/existing subscriber = 1452 + (3758.28/223) = $23.36
Every year, i increase the revenue/subscriber by 5% and cost/subscriber by 2%.
I value the existing subscriber at $657, giving the value of existing subscribers at $146 billion for $223 million.
Value of New Subscribers
I derive the value of new subscribers by adding the total marketing cost for Netflix and then dividing this amount by the gross increase in the number of subscribers.
Marketing expenses at 7% of revenues give $2192 million.
At a 95% renewal rate, the gross addition of subscribers = Total subscribers for the current year – 95% of last year’s subscribers. I assume that at the end of every year, 5% of subscribers leave Netflix.
The cost/new subscriber = $108.5
The value of existing subscribers = $657
The value of new subscriber = $657 – $108.5 = $549.47
I assume that the value of new subscribers will increase at a risk-free rate annually, and Netflix will grow its subscribers by 11% annually for the next ten years. Furthermore, I assume that Netflix’s subscriber count will grow by 11% because India is primarily an untapped market, and there is potential for Netflix to grow its market share.
After ten years, Netflix will grow subscribers by 1% in a steadily state.
Then i discount the value at the cost of capital to get a total value for Netflix’s new subscribers.
I value Netflix’s new subscribers at $317 billion.
Valuing Corporate Costs
I allocate 80% of the content and 100% of the technology costs to corporate expenses. I assume that these costs will increase by 3% annually. I assume that Netflix will continue to spend on new content and licensing costs which is evident by the fact that Netflix ranks among the top five global spenders in the content business. I discount the corporate expenses at the cost of capital to determine the present value of the corporate drag.
I value the corporate drag at $311 billion.
Netflix Equity Value
Finally, i value Netflix by adding value to existing and new subscribers and netting the corporate drag.
Value of Netflix = Value of Existing Subscriber + Value of new subscriber – Value of corporate drag
The value of Netflix’s Operating Assets is $153.2 billion.
Then i subtract the debt and add cash to derive the equity value.
Current outstanding shares are 445 million.
Thus, the value/share = $320
Currently, Netflix trades at $291/share and Netflix trades at a discount.
My valuation rests on the assumption that Netflix can grow subscribers by 11% annually for the next ten years while keeping the content costs in control.
Analysts must understand a firm’s business model before valuing a company. Unfortunately, accounting numbers fail to give the right inputs for a DCF valuation. As a result, analysts looking at the DCF model as an excel exercise or financial engineering will value a firm incorrectly or fail to understand the metrics driving valuation.
Thus, we need to understand the firm’s strategic assets and value drivers to understand its value creation. For instance, in our Netflix valuation, the value drivers are growth in subscriber additions, churn rate and growth in content costs. However, we cannot apply this approach to other subscription players like Spotify because, for Spotify, the content costs are variable. Thus, Netflix has a levered business model compared to Spotify. So if Netflix can add subscribers by controlling the content, it will deliver higher value than Spotify. However, if Netflix fails to grow its subscribers or fails to control its content costs, it runs the risk of bankruptcy.