Netflix Case
MGT 180R – Business Finance
Netflix (ticker: NFLX) began as a DVD rental service when it went public in 2002, but it achieved massive success ever since it began offering a streaming service. There are now many players in the streaming service business, and so a considerable amount of uncertainty exists surrounding Netflix’s future. The purpose of this case is to apply your capital budgeting skills in a valuation of Netflix.
Think of valuing a company like a big capital budgeting exercise. However, instead of forecasting cash flows for a single project, you will be forecasting cash flows for an entire company. Likewise, instead of computing the NPV of an individual project, you will compute the NPV of the cash flows of the entire company. There will be one key difference: with projects we typically assume they come to an end, but with companies we don’t (at least we hope not!). Thus, we need to make an assumption about how cash flows in the company grow in the long run. Typically we forecast individual cash flows for 5-10 years and then make an assumption about how cash flows grow after that (more details on this below). Here are the steps for the Netflix case:
1. Start with the Netflix excel worksheet I’ve posted on Canvas (Netflix.xlsx)
2. The spreadsheet gives assumptions about the year-over-year (YOY) growth of revenues and related expenses for 2025-2032. These assumptions come from analyst reports and Netflix management forecasts. Combining these sources gives a bumpy growth forecast for the next few years which is why the YOY growth estimates do not follow a smooth pattern at first. Use the base case assumptions in the excel sheet to build a forecast of earnings and free cash flows for the years 2025 to 2032. Specifically, start by forecasting revenues each year. Then, using these forecasts, compute the associated “cost of revenue”, depreciation and capital expenditures. Cost of revenue are all costs of revenue not including depreciation, so that Revenue – Cost of Revenue = Earnings Before Interest Taxes Depreciation and Amortization (EBITDA). Subtract off depreciation to get EBIT. Continue as we did in our capital budgeting exercises until you eventually get to Free Cash Flow. You can assume a tax rate of 21% and negligible changes in net working capital. You can also assume an opportunity cost of capital of 10% for all the FCFs.
3. Beyond 2032, you will need to make an assumption about Netflix’s long-term growth once its growth stabilizes.
• Start with the free cash flows you forecast for 2032 and assume that they will grow by 6% to 2033 and continue growing at 6% thereafter. You can then use the growing perpetuity formula to value all the cash flows after 2032. By doing this, you will have what is called a “terminal value” or “continuation value” for Netflix as of the end of 2032 (one year before the first cash flow in the growing perpetuity).
4. To avoid timing complexities, we will assume that it is now the beginning of 2025 and that the first cash flow (the 2025 FCF) will be generated exactly one-year from now, at the end of 2025. Discount all cash flows back to the beginning of 2025 using a 10% cost of capital. The sum of total of these discounted cash flows is the estimated total enterprise value of Netflix at the beginning of 2025. Enterprise Value = Equity + Debt – (Cash and Marketable Securities).
5. To arrive at the price per (equity) share, you must subtract Netflix’s debt from its enterprise value and then add Netflix’s cash and marketable securities.
• Netflix has $15.6 billion in debt and $9.6 billion in cash and marketable securities.
• Netflix has 437.8 million shares outstanding. Use this information to calculate the price per share.
6. Next, perform some sensitivity analysis.
• Given the uncertainty in the competitive environment for streaming services, use the Upside and Downside scenarios for YoY revenue growth to compute the associated Upside and Downside stock prices.
• Also, using the base case, check the sensitivity of your valuation to the assumptions about Netflix’s cost of revenue. The sheet assumes that Netflix will be able to stabilize its cost of revenue to be 60% by 2032. However, competition for streaming content, higher product support expenses, or increased advertising could eat into this. Calculate Netflix’s stock price if Cost of Revenue evolves as in the “Sensitivity CoR” row in the spreadsheet.
7. As of the writing of this case, Netflix’s stock price was $950.
• Consider what it would take for your forecast to produce a valuation that equates to a $950 stock price.
• By changing your revenue growth assumptions, find a set of YoY growth assumptions that would produce a stock price of approximately $950. (The growth rates that you come up with do not have to be the same across the years, and there is no single correct answer: many different sets of growth rates will produce a price of $950.)
• With these revenue assumptions in place, compute the compound annual growth rate (CAGR) in FCF from 2025 to 2032. For example, if your estimate of 2025 FCF is $1,000 and for 2032 is $10,000, then you would use the “RATE” function in Excel: =RATE(7,0,-1000,10000).
8. An alternative way to value a stock is by use of multiples. NOTE: There is no reason to expect the multiples-based valuation to agree with your discounted cash flow (DCF) valuation. This may be true for a couple of reasons: 1) It is difficult to find a reasonable comparison company, and 2) Netflix may command a premium (or discount) valuation depending on its fundamentals.
• Start by valuing Netflix based on your 2025 projected EBITDA and using the entertainment industry average Enterprise Value/EBITDA ratio of 16.4. This will give you a total company value which you would replace your NPV of FCF in your share value calculation (you still need to subtract debt and add cash and marketable securities before dividing by shares outstanding to get the price per share).
• Do the same with the average EV/EBITDA ratio for Internet-based companies: 19.3.
Overall, what is your estimate of what Netflix’s stock price should be and what range of valuations do you think are reasonable? Defend your conclusion by discussing and referencing the outcomes of the valuations in steps 5 to 8. You will have arrived at a range of prices and you will need to take a stand on how to interpret this range and which prices and assumptions to weigh more heavily. Your answer should take the form. of a memo (maximum 2 single-spaced pages) that references the spreadsheet exhibits (the exhibits do not count toward the 2-page limit). Do NOT write a chronological history of what you did to solve this case and do NOT write it as #5) answer, #6) answer, etc. You are supposed to explain the highlights of your approach, synthesize what you found, draw a conclusion, and defend it.
This is a group case with a maximum number of five people per group. Submission is electronic via Canvas with one submission per group. Submissions MUST also include your Excel file ending in .xlsx. Please make sure your Excel file is not corrupted before submitting, and please list the name of each group member in your submission.