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Netflix and Warren Buffett

- By Rupert Hargreaves

Apart from Tesla (TSLA), Netflix Inc. (NFLX) has to be one of the most controversial stocks on the market.

There appears to be two main camps of investor opinion. Some renowned investors like the company while others don't. Likewise, some value investors like the company and others don't.

There are those who believe Netflix is a highly valuable brand and, while the company may be hemorrhaging cash today, this investment is worth it considering the long-term opportunity the business has to capture eyeballs and generate cash. Investors who fall into this camp believe the stock's current valuation of nearly 100 times forward earnings is a price worth paying for its future potential.


On the other hand, bears think the company is spending too much money on content, raising too much debt and will never be a self-sustaining business. Netflix's current valuation is too much for investors who believe this to be the case.

Personally, as my investment strategy is built around cash, I have never been interested in Netflix because the company is not generating enough cash to be self-sustainable and has a relatively weak balance sheet. Because it does not meet these two criteria on my investment checklist, I cannot consider it for my portfolio.

Having said that, I can see the appeal of the business from a growth perspective. Even though it has a market capitalization of $153 billion, the company is still relatively small by global standards. According to its latest results, Netflix added nearly 29 million subscribers globally in 2018, marking its best year for customer growth with almost 140 million subscribers globally by the end of the year. If we take that and compare it to the number of people who use Facebook (FB) (I am using as a proxy for internet access and the desire to consume online content), which was 2.3 billion at the end of the third quarter, it is easy to conclude Netflix has a tremendous runway for growth in front of it. This ignores the fact that the company will need tens of billions of dollars in funding over the next several years to accomplish this global domination.

What does Buffett say?

Netflix could grow substantially from its current levels, but will it?

This question is impossible to answer -- unless, of course, you can see the future -- and I am always reminded of Warren Buffett (Trades, Portfolio)'s famous quote on valuing businesses when looking at situations like this.

In his 2000 letter to investors of Berkshire Hathaway (BRK-A)(BRK-B), the Oracle of Omaha wrote:

"Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush 3/4 and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars."

When it comes to evaluating Netflix, at this point, we cannot with any certainty answer any of the three questions above. We know Netflix could be hugely successful, but we don't know when it will finally be self-sustaining, and we cannot be sure how profitable it will eventually be. Interest rates are a different factor altogether.

Until we have the answers to these key questions, Netflix will remain speculative.

Disclosure: The author owns shares of Berkshire Hathaway.

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This article first appeared on GuruFocus.