This year has been tough on former high-flying stocks, and the low prices have tempted investors to buy the dip. Of course, not all stocks that have taken a beating are a buy. However, if you’re looking to build your portfolio of stocks with significant upside potential, Netflix (NASDAQ: NFLX) is one to consider.
By May 2022, shares of NFLX traded under $200. Considering NFLX’s 52-week high was closer to $700, this fall has been near catastrophic for those who bought close to the highs.
To see if the current prices are a reason to sell or buy the dip, we examine the company’s valuation, revenue growth, drivers of growth, and other key variables to make a more informed decision.
Netflix Volatility Bucks Most Investors Off
Since going public in 2002, when shares were just $15, Netflix has produced millionaires galore. In the intervening years, the company has split its stock twice — in 2004 (a 2-for-1 stock split) and in 2015 (a 7-for-1 stock split).
If you purchased 100 shares of NFLX on the day of its IPO and held onto it until today, you would have 1,400 shares. Even at current prices, early investors are still in the black. But to hold on over that time period required a firm resolve because NFLX share price has had a dramatic history of price swings, often rising and falling by as much as 30% in a day.
The most recent sharp decline has caused high profile investors to lose faith. Former Netflix fans, like Bill Ackman, have sold all their shares after going “all-in” just a few months earlier. With prices going backwards and so much pessimism, is there any reason to buy?
The Bull Case: Valuation
After the recent sell-off following the company’s first-quarter 2022 financial results, the company’s valuation has hit a multi-year low.
When we performed a discounted cash flow analysis forecast, Netflix had a fair market value of $298 per share, representing 56% upside.
The company is still selling for an elevated price-to-earnings premium of 52.8x, so it’s still not a deal on earnings multiples. But earnings are forecast to rise sharply in the coming years:
- EPS 2022: $11.02
- EPS 2023: $12.30
- EPS 2024: $14.96
- EPS 2025: $17.21
- EPS 2026: $21.41
Arguably, Netflix trading at under 10x 2026 earnings is too tempting to ignore now, especially for value-oriented investors. Another metric in favor of the bulls is margin.
Since 2016, Netflix has been increasing its annual operating margin by around 3% per year. In the coming fiscal year, Netflix is targeting a 19%–20% operating margin.
Gross profit margins have been on the rise too, increasing from:
- 31.3% in 2017,
- 36.9% in 2018,
- 38.3% in 2019,
- 38.9% in 2020, and
- 41.6% in 2021
The Bear Case: Slower Growth
As competition increases, concerns surround Netflix’s lower-than-anticipated subscriber growth. In the past quarter, subscribers went backwards for the first time; the company lost 200,000 subscribers.
This U-turn has translated to slower revenue growth. Despite these concerns, the company’s revenue has continued to increase year over year.
- Annual revenue in 2019 was $20.15 billion, a 27.6% increase from 2018.
- Annual revenue in 2020 was $24.99 billion, a 24.01% increase from 2019.
- Annual revenue in 2021 was $29.69 billion, an 18.8% increase from 2020.
While focusing on revenue growth, it’s important to consider the drivers of growth influencing Netflix’s revenue today and the potential drivers for the future. For example, Netflix is expanding into international markets, which management hopes will re-ignite growth. Even if growth in the United States plateaus, Netflix’s focus on international expansion can sustain growth for the foreseeable future.
Nevertheless, the bears contend that a saturated U.S. market, and the company’s consideration of a lower-price tier plan that is ad supported is evidence that it has maxed out its pricing power.
Another bear argument is heightened competition.
Netflix once dominated the streaming market, but since 2016, its market share has declined. According to IBISWorld, Netflix controlled 31.5% of the online streaming market in 2016, but by 2020, that share eroded to 27.6%. Today’s most prominent competitors are YouTube, Hulu, Disney, and Amazon.
Bears contend that Netflix lacks the brand moat that Disney possesses while bulls point to its Original Content as evidence of a hurdle difficult for competitors to disrupt. YouTube doesn’t pay content providers upfront, but supports them with a cut of ad revenues after they have generated views. Netflix, by contrast, must finance content costs upfront before it can monetize them. This causes Netflix to go deep in the red from a cash perspective before it can climb out of the trough of the investment J-curve.
Should You Buy Shares of NFLX?
Viewed through the lens of valuation, Netflix is currently on sale. But a tectonic shift has occurred where subscriber growth has slowed and Netflix has largely saturated its most lucrative market, the United States.
Big investors like Bill Ackman have fled the stock already and the share price is weak. For investors keen to snap up a deal, wait for Netflix to form a base and breakout before buying the drip. It’s impossible to know how much lower a stock will go after it has fallen this much. Rather than catch a falling knife, wait for the dust to settle and you could end up with the deal of the decade.