netflix share price: what the drop in netflix share price tells us about the valuation of indian companies
Many have wondered how a reduction of 200,000 subscribers paying a few dollars a month could lead to a reduction of more than $200 billion in Netflix’s market capitalization. In today’s column, I explain the math behind this seemingly crazy event. More importantly, we often associate these new era tech startups with this kind of stock market behavior. But in India, there is a twist. Continue reading.
Essentially, the value of any business is the present value of all its future cash flows. The simplicity of this statement hides the difficulty of what the process involves. The key words are “future cash flows” and “present value”. Many assumptions must be made (such as revenue growth, cost inflation, capital expenditures, etc.) to determine future cash flows and discount them (at the weighted average cost of capital rate) to the value current. The cost of capital is in turn based on the risk-free rate of return and the equity risk premium.
The two variables we want to focus on here are the growth rate and the risk-free rate. While the interest rate the US government is paying on its 10-year debt (US10Y) is widely considered risk-free, the expected rate of growth is company-specific. We will play with these two variables to assess what happened.
Not long ago, the Federal Reserve decided that inflation, due to years of accommodative monetary policy, was spiraling out of control and the only way to bring it under control was to raise rates. When the Fed started communicating its intention, the market got the hang of it and started to revalue assets. The US10Y has risen from a low of 1% to near 3% recently.
Are we really worried about a few percentage points increase in interest rates, one might ask. Well, its importance depends on many things, but it boils down to one variable: terminal value as a proportion of net present value. The higher the percentage, the greater the problem with rising interest rates. We’ll come back to that in a moment.
The second variable at hand is the growth rate of individual firms. While each participant (analyst, institutional investor, retail investors, etc.) will have their estimates, it is the collective median (consensus) that counts. In a market fueled by liquidity, it is easy to err on the side of optimism. Investors later realize that things might not be as good as they initially thought, and reality sets in. Sooner or later it always does.
The combined effect of rising interest rates and slowing growth can be massive. Take the case of Netflix. The stock price at its peak (November 2021) was around $687 per share. Assuming an interest rate of 1% US10Y (quite correct at the time), if we work backwards, the market expected Netflix to grow its free cash flow at a rate annualized by 40% per year for the first decade. Since then, US10Y has risen to 3% and Netflix has fallen 68%. If we now backcalculate, the growth rate is revised to just 28%.
In other words, the total decline in Netflix stock can be justified if one assumes that the growth rate (for the first decade) slows from 40% per year to 28% per year and that the risk-free rate increases from 1% to 3%. %. That’s it! See the chart for a few other Nasdaq quotes.
Now back to the point we put a pin on earlier: terminal value. Businesses survive beyond what we think we can explicitly predict. Therefore, we arrive at the value of a company at the end of the forecast period (10 years in our case, using much lower growth assumptions). It is the terminal value of the company.
The higher this number as a proportion of net present value, the greater the impact of interest rates on valuations. For Adobe, terminal value is a much smaller proportion of net present value today, and therefore a much smaller relative decline in share price.
The statistics are revealing. Stocks are down 70-90% and it’s not like the markets have started pricing in negative growth rates. If so, the drop in the implied assumption is miniscule. It’s easy to exclaim “it can happen any day, what were people thinking”.
In India, this story has a little twist. A few tech names exhibit similar characteristics, such as Nasdaq stocks. But unlike the West, a few consumer names are also eligible. See table below.
For these consumption stocks, the terminal value is equally important as a percentage of the net present value. Nevertheless, the decline in stock prices from recent highs is solely due to rising interest rates. In other words, despite the dramatic rise in inflation, the street is not worried that free cash flow growth for the next decade could be negatively affected.
The recent Russian-Ukrainian conflict has led to an increase in the prices of agricultural products. This increases rural demand and Streets’ assumption may not be wrong. Not for now, at least. But in the times to come, I sincerely hope that we won’t have to ask ourselves the same question: “What were we thinking?”