You Might Be Thinking About Netflix All Wrong

Whatever your leanings on Netflix, this week’s results confirmed one thing: its transition from an impossible-to-turn-down, one-price-subscription growth machine to a multi-tiered, multi-revenue-source media company will take some time yet. The best thing to do, then, is think about the end game – or at least, what the firm will look like in, say, ten years. When I ponder what Netflix might look like in the future, I can’t help but take a trip down memory lane.

Previously, in TV.

When Netflix came along, it went to war with the fat and happy TV industry. The streamer was cheap to consumers and free from all that annoying advertising (and, yes, you could also binge-watch on demand too). That forced all media firms from CBS to Disney to follow suit, and launch their own direct-to-consumer streams. Now, more than a decade later, streaming’s growth has started to dry up, and that’s forcing the original disruptors to go hunting for those old-school advertising dollars. And, basically, it looks like we’ll end up back where we started – only instead of paying one subscription lump to Comcast or other distributors, we’ll have to manage a portfolio of streaming payments. Funny how things turn out...

There is a point to this nostalgia. When I think about the end game for Netflix I keep coming back to ESPN. For one simple reason. Before streaming was a thing, ESPN was a must-have channel, adored by viewers and advertisers alike. And that’s exactly what Netflix wants to be. So I reckon using ESPN as a benchmark for valuing Netflix is a useful exercise – especially now that the “new” TV ecosystem is looking more and more like the old one.

See, for years, ESPN was the undisputed champ of the TV network business. The sports juggernaut was the bulk of parent Disney’s profit, riding high on a reliable dual-revenue stream of advertising and subscription fees – which cable firms like Comcast paid to Disney for the right to distribute ESPN (along with other Disney channels).

And the all-day, every-day sports hub was loved by investors for a couple of reasons.

Firstly, there was that “must-have” component. Households up and down the country demanded live sports entertainment (even if they only tuned in once or twice a week) and that gave Disney a handful of aces when it came to negotiating subscription fees with its cable company distributors – the Comcasts and DirecTVs of the world. So every few years when negotiators from Disney and Comcast (for example) sat around the table to discuss a new distribution deal, Disney knew it had the cards, and walked away with bumper price increases each and every time.

Secondly, the average ESPN viewer (male, age 18 to 35) was deemed to have the most disposable cash (thankfully, we’ve moved on from that view), and so the network was considered the holy grail for advertisers.

What all that meant was that investors were prepared to stick a high price tag on ESPN (remember that ESPN was part of Disney, so investors valued it separately, as part of their assessment of the parent). Anyway, using the traditional media valuation multiple – enterprise value to earnings before interest, tax, depreciation, and amortization (EV/EBITDA), ESPN tended to be benchmarked around an impressive 15x. Back then, Apple’s shares traded around 10x and Microsoft’s around 14x, for comparison.

Up next.

Now, there are a couple of reasons why Netflix shouldn’t be as valuable as ESPN. For one, it might not be able to continue to successfully jack up prices: indeed, if anything, Netflix is cutting prices at the moment, by introducing ad content. For another, its hit-or-miss content lineup is less reliable than SportsCenter or Monday Night Football.

But there’s also one big reason why Netflix could be more valuable. ESPN doesn’t travel well, so it’s essentially limited to a US audience (around 100 million households). Netflix, by comparison, already has more than two times that, and it’s still growing.

So let’s say ESPN’s 15x multiple is fair, then, and use that to value Netflix. Now, this process takes a few assumptions: first to calculate a future EBITDA, then a future firm valuation using that 15x multiple, and finally a conversion back to today’s money. You can see the workings here. The main assumptions (which I think are reasonable) are:

• Subscribers will continue to grow at the current 5% levels.

• Average revenue per subscriber (which is limited now to subscription but will increasingly include advertising) will grow by 5%.

• EBITDA margin will climb to 25% (ESPN in its prime was closer to the mid-30s)

By my math, the combination of those assumptions, and that 15x EBITDA multiple spits out a market valuation today of around $155 billion, or $330 per share – miraculously close to today’s price. That’s probably not a coincidence – markets are fairly good at pricing stocks efficiently, after all. But what this does is give you a new framework to think about Netflix’s worth. And it really comes down to one thing: will Netflix be as valuable as ESPN has been, and what advantages and disadvantages does it have?

The way I see it, that’s the right way to think about Netflix as it makes this transition. And after this, I’m sitting on the fence, at least for a while.