As the share prices of tech giants Facebook, Amazon, Netflix and Google powered their way through 2015, the market started to group them under the less than imaginative banner of ‘FANG’. By adding in LinkedIn and juggling the letters, however, you reach the more appropriate ‘GNALF’ – the sort of strangled sound investors in those companies are likely to have been making for much of 2016.
Since the start of the year, the tech sector has been on a downward slope and the GNALFs have led the way. Amazon, for example, saw its share price drop 13% after disappointing the market with its fourth-quarter numbers. The company had committed the sin of reporting, among other things, full-year sales that were up 26% on the year before and which had passed $100bn (£72bn) for the first time ever.
Ahead of the announcement, Amazon’s share price had risen strongly as the market anticipated what one analyst called a ‘blow-out’ quarter but those gains reversed when the ‘blow-out’ failed to materialise. Commenting on the 13% fall, the FT’s Lex column drily noted: “If you were willing to pay 900x earnings on Thursday morning, there is no reason to abandon the rocket ship a day later.”
That seems reasonable enough but of course reason is often in short supply in the technology sector. This is at least partly because profits often are too, leading the market to rely heavily on revenues when it comes to valuing tech stocks. Should a company’s revenues, for whatever reason, fall short of the market’s expectations then, its share price can take a pounding.
So it proved with LinkedIn last month as the company saw its share price fall 28% in a single day to leave it at around half the peak it had hit the previous year. To be clear, the company had actually enjoyed a good end to 2015, with fourth-quarter revenues slightly ahead of forecasts, but the market was unhappy it had edged back its guidance on revenue growth in 2016.
All LinkedIn did was lower expectations but this was enough to see more than $7bn wiped off its value – particularly as the announcement coincided with investor sentiment turning a lot more defensive. As the Lex column put it at the time: “When defensive securities are suddenly prized, the only growth tech stocks that will survive a portfolio cleanse are those whose revenues do not miss a beat.”
With expectations, whether beaten, matched or missed, being so important in the context of technology investing, what then to make of another of the GNALFs – Netflix? Earlier this year, the video content streamer announced its intention to go live in every country in the world – with the fairly important exception, at least for the time being, of China.
Still, while that all sounds very exciting, there is of course no guarantee Netflix will succeed in all those countries. Clearly Netflix has done very well in the UK as well as in some other Western markets but the stark reality is that the company has yet to make a profit – and that poses a problem for anyone who is looking to invest for the longer term.
If you want to invest in Netflix today, you really have to believe in its future growth potential. And not just in the growth of its revenues, on which much of the market seems so fixated – you have to believe in the growth of the profits and the cashflow of the business. To see just what such a belief entails, take a look at the following table:
Source: Schroders, Netflix, Wikipedia, Internet Live Stats, 2016
Granted, this represents a very simple financial analysis but we believe it does the job. As you can see, at the end of last year, Netflix was valued at $50bn having generated $7bn of revenues – and barely any profit worth the name. Again, at the end of last year, the company had 66 million subscribers which, on some very basic maths, equates to about a 3% market share of all the households in the world.
So how might we earn a return from here? Let’s assume we are after a return of 10% a year over the next decade to compensate for the risk of owning the stock. Netflix’s current $50bn valuation would thus need to be worth $130bn by 2025. Our subsequent calculations necessarily involve a number of assumptions, which you can see in the notes, but they are all in line with the average US business.
That being so, Netflix would need to have upped its revenues from $7bn to almost $200bn – a growth rate of 40% every year for 10 years. If that seems ambitious, just think how many subscribers Netflix will need by 2025 to make that happen. Assuming the number of households globally grows by 3% a year, that means almost three billion by 2025 – and Netflix would have to have 70% as subscribers.
That is quite some market penetration but it is effectively what you need to believe Netflix can achieve if you buy the company on its current valuation. Still, if you felt our 10%-a-year growth rate illustration involved a few too many assumptions for your tastes, let’s just think what it would take to justify Netflix’s current share price to the extent that you see no further share price growth.
Even then, Netflix would still have to sign up 35% of the world’s households as subscribers. So that would mean a jump from 3% to 35% right this instant – or, to give the company a chance, by the time you finish this article. However absurd that idea may be, it is even more so when you consider only 40% of the world’s households today actually enjoy internet access.
In other words, to justify even its current share price, Netflix ought to have signed up roughly 90% of the world’s available market of internet users – and that is before we even broach the question of subscription prices, which would presumably be much lower than the average Western level of $100 we have used in our maths. On any measure then, Netflix has some huge expectations to live up to.