INTRODUCTION

Netflix is the world's largest online movie rental service, providing more than six million subscribers access to over 70,000 DVD titles. The company offers a variety of subscription plans, starting at $5.99 a month. There are no due dates, no late fees and no shipping fees. DVDs are delivered for free by the USPS from regional shipping centers located throughout the United States. Netflix offers personalized movie recommendations to its members and has more than one billion movie ratings. Netflix also allows members to share and recommend movies to one another through its Friends feature. For more information, visit www.netflix.com.

Based on Netflix's historical financial statements and our forward-looking statements, we will do finance analysis for the company.

How is Netflix positioned in its industry for growth?

Since 1999, DVDs have been greatly adopted as a medium for home entertainment. Netflix has grasped this opportunity and finally has established its leadership position in this market.

English: A Netflix envelope picture taken by BlueM...

English: The headquarters of Netflix in Los Gatos.

Netflix

Now Netflix is the largest online movie rental corporation. Its outstanding performance in the market is indicated in its financial statements in the past 5 years. First, we examine its 5 years' trend of financial ratios, and secondly, we compare those ratios to its competitors. Table 1 is key ratios for the past five years.

Table 1

Above ratios show Netflix's successful performance just right after the inception of business. Profit margin, basic earning power ratio, return on assets and return on equity are all negative in the first two years. These negative numbers are typically present in start-up companies such as Netflix. However, Netflix becomes profitable since 2003, shortly after its inception, which turns all these rations into positive. Moreover, they are increasing rapidly. The decrease in basic earning power ratio in 2005 is not a cause for concern because it is merely the result of the tax credit. Indeed, return on assets and return on equity is 11.52% and 18.58% respectively, increasing by 3.5% from those of 2004.

We also compare the average of these ratios to those of its competitors. The market of film entertainment is full of competition and these companies are subject to the change such as the technology to process deliveries and the price of DVDS. Netflix has a huge range of potential competitors including video rental outlets such as Blockbuster and Movie Gallery, online DVD subscription rental sites such as Blockbuster Online, pay-per-view and VOD services and alternative content delivery methods such as Apple's video iPod and Movie Beam, movie retail stores such as Beat Buy, Wal-Mart and Amazon.com, subscription entertainment services, such as HBO and Showtime, Internet movie providers such as Movie link, Internet companies such as Yahoo! and Google, Cable providers such as AOL Time Warner and Comcast and direct broadcast satellite providers such as DirecTV and Echostar. Here we make a comparison among Netflix and its main rivals who challenge Netflix directly. Through the Table 2 below, we can have a better idea how it positions in the home entertainment market.

Table 2

Netflix has a higher current ratio than the average of its industry and it shows Netflix could liquidate current assets at only 53 percent of book value and still pay off current creditors. Netflix's fixed assets turnover ration of 6.1, much higher than the industry average of 3.5, indicates Netflix uses its plant and equipment more effectively than the industry's average performance. Netflix's total assets turnover ratio is somewhat above the industry average, but not as far above as the fixed assets turnover. This is due to Netflix has less fixed assets in relation to its total assets than the conventional movie rental companies such as Movie gallery and Blockbuster. Netflix does not own real estate; instead, it leases the property. It gives Netflix some degree of flexibility because it can reduce or increase the property depends on its needs. The debt ratio of Netflix is 43.24%, lower than the average 54.03%. The lower the ratio is, the greater the ability to be against the losses becomes in the event of liquidation. Netflix's profit margin on sales, basic earning power ratio, return on total assets and return on common equity are negative and worse than the industry average level because Netflix incurs a huge investment in Technology and development and marketing costs in the period of inception. These facts are excluded from our analysis because these costs are reasonable for the company which has just started business, and Netflix is the only start-up company among them.

Since its inception, Netflix has established its reputation, attracting more consumers. It has provided more service and these activities greatly improved the revenue, resulting in a positive operating income in 2003. It did even better in 2004 and 2005. Since Netflix has just launched its business, we had better to use the data after 2003 as index to compare with its rivals. Netflix's profit margin on sales; basic earning power ration; return on total assets are all positive while the industry average level is negative, which indicates Netflix got a higher return as a result of its ability to use its assets effectively. The Price/earnings ratio of 50.3, which is much higher than the industry average of 12.9, indicates Netflix is less risky than its competitors and has a brighter growth prospects.

Netflix has done a great job in the past 5 years; its key ratios are excellent and much better than the industry average. We can infer that Netflix focuses on retaining the leadership position and growing its business so it can maintain its leadership in the industry for a long time as long as it can keep its own competitive advantages.

2. What has been the historical growth rate of Netflix over the past 5 years?

The following table shows Netflix's growth data for the past five years.

Table 3 Historical Data and Growth Rate

Based on Table 3, we can calculate the average growth rate from 2001 to 2005:

Total revenue: (103.11%+79.30%+85.13%+36.28%)/4=75.96%

Net income(loss): (46.54%+131.09%+231.62%+94.61%)/4=125.97%

EPS(Basic): (93.10%+118.92%+200%+88.10%)/4=125.03%

As shown above, Netflix is rapidly growing as the online DVD rental market grows. From 2001 to 2005, the average growth rate of total revenue had reached 75.96%. The growth had been fueled by the rapid adoption of DVDs as a medium for home entertainment as well as increasing awareness of online DVD rentals. In addition, the growth has been driven by its comprehensive selection of titles, consistently high levels of customer satisfaction and its effective marketing programs.

Netflix's net income turned to be positive since 2003 and the average growth rates for the five years were 125.97%. This means Netflix has gradually been recovering the initial investment in operating costs at the beginning. Also, the online DVD rental transaction went on well year by year, which causes the growth rate of revenue to be bigger than that of operating costs. The effects can be seen in the increase in profit margin. As a result, we can estimate that Netflix can maintain a stable, positive growth rate in the foreseeable future. (See more detailed reasons in question 6).

3. What do you expect the growth rate of Netflix to be over the next 5 years?

Netflix's past growth results from its ability to maintain high market share and its efficient business model. Our analysis of its future growth based on its past performance in terms of market share and financial ratios from our projected financial statements over the next five years.

First of all, our estimation of the growth rate of Netflix begins with analysis of the past five years growth rate of online subscribers because Netflix revenue substantially comes from monthly subscription fees. As shown in Figure 1, the total market has grown from 0.9 million subscribers in 2002 to 8.8 million at the end of 2006.

Figure 1

Source: "Netflix Corporate Fact Sheet" Netflix. 15 April, 2007.

<http://files.shareholder.com/downloads/NFLX/86912410>.

Table 4 shows that Netflix market share from 2002 to 2006. Although Netflix has enjoyed rapid subscriber growth for the 5 years, its market share has decreased from 95% to 75 %. The decrease of market share can be explained by increasing competition. For example, Blockbuster started online service in 2004, and try to eat shares from Netflix announcing their Total Access program, which allows online customers to make a choice between returning their DVDs through mail and exchanging them at more than 5,000 stores for free in-store movie rentals. The rapid growth of Netflix whips companies with large financial resources into the online rental market, such as Apple, Amazon, Wal-Mart, Google and Yahoo!

Table 4 Netflix Market Share

Although the online rental market is expected to experience increasingly intense competition in the next five years, we assume that Netflix maintains 75% market share. The reason for this assumption is Netflix has successfully gained its reputation for high quality services such as a next-day delivery and its catalog 75,000 titles. It also has proprietary software that swiftly sorts DVDs and a strong relationship with various filmed entertainment providers and the U.S. Postal service. Moreover, it responded quickly to a rapid change of the market by launching a downloading service "Watch Now." Therefore, we estimated that Netflix would maintain 75 % market share for the next five years.

However, Netflix may need to decrease its subscription price due to intense competition. It currently offers price packages ranged from $4.99 to $23.99 and the average subscription revenue from a subscriber is $13.60 per month. We estimate the average price will be decrease to $10 per month.

The following table shows estimated subscribers which Netflix will hold each year and estimated revenue from subscription for the next five years.

Table 5 Estimated Revenues and Growth Rate

Estimated Netflix Subscribers is determined based on a market analysis by professional researchers. According to Adams Media Research and Netflix internal estimates, the total market will have more than 20 million online subscribers in the next four to six years. We estimated the total market would have 20 million subscribers in 2010 and 75 % of the total market would be retained by Netflix. Revenue for each year is determined by multiplying a price that a subscriber will pay each year and the average number of subscribers for the year. Therefore our estimated growth rates for the next five years are 46%, 25%, 17%, 13 % and 9% respectively.

Next, financial ratios from our projected financial statements over the next five years should be examined to see how an economy of scale is realized by the company.

The results are as follows:

Table 6 Projected Key Ratios

Table 6 shows that Netflix successfully achieves economies of scale with its efficient operation as Netflix claims "Scalable Business Model." Fixed and total assets turnover is increasing each year, which indicates Netflix effectively manages its assets. Increase in profit margin shows that cost declines relative to revenue. Some of operating costs do not need to grow as revenue increase. Marketing costs will even decrease in near future when the company will have had broad brand recognition. As a result, Basic earning power ratio, ROA, and ROE all increase each year. The company may have a trouble because of decrease in current ratio due to large increase in account payable. It has also a negative sign in debt ratio; however, its debt consist of all arise from its normal course of business. Therefore, its interest expense is kept small.

Based on our assumption discussed above, we predicted that net income would have grown from $40 million to $126 million in the next five years.

4. How will Netflix finance that growth?

Netflex will generate enough revenue to support its growth for the next five years, so the company does not need to issue debt or stock. It is beneficial for the both the company and its shareholders because not borrowing debt minimizes Netflix's financial risk and not issuing stock prevents shareholders to experience dilution. Netflix keeps taking these advantages by maintaining market leadership and realizing economies of scale.

In order to maintain its market leadership, the company should expand a large internet-based movie delivery as that market develops. Netflix has competitive strengths such as rich content, personalized choices, persistent innovation, and fast delivery. Besides keeping these advantages, the company needs to provide compelling value for subscribers. The company needs to utilize technology to enhance subscriber experience and operate efficiently.

The ability of generating internal earnings also comes from its efficient operation. The company has built mutually beneficial relationships with filmed entertainment providers. It does not own any real property, and utilizes part time employees effectively in order to respond the demand. All of those helps Netflix built a scalable, low-cost business model designed to maximize their revenues and minimize their cost.

Based on the above information, we forecast the pro forma financial statements for the next 5 years. The subscription and fulfillment expenses grow directly with revenue growth rate. We set the growth rate of forecast operating expenses is lower than growth rate of forecast revenue because it is reasonable to estimate these costs decreases year by year. For example, marketing costs decrease as the company attains more brand recognition, so as technology & development costs as the company establishes its system. The assets are tied directly to revenue growth rate. The growth rate of liabilities is the average for growth rate of revenue expenses and operating expenses. Based on the AFN formula, we can find out the AFN is negative. That means that the company does not need additional financing. The company can add short-term investments, repurchase treasury stocks, or pay dividends. In this case, we choose to pay dividends to investors.

5. What is Netflix's dividend policy?

We assume Netflix's dividend policy is to maximize a shareholder's wealth by distributing steady dividends from its residual earning instead of repurchasing stock.

The dividend decision is made in hope of a reduction of investor uncertainty of future free cash flow. We assume that Netflix's shareholder relatively prefers returns as dividend yield to capital gains. Moreover, Netflix currently does not need to repurchase shares to use for Employee Stock Purchase Plan and Stock Option Plans because it has reserved enough shares to cover those plans. Target payout ratio is determined based on Residual Distribution Model shown in Table 7. Netflix does not have any debt except debt arise from its operation as of December 31, 2005. It is expected to maintain its capital structure for the next five years.

Table 7 Distribution Schedule based on Residual Distribution Model (in thousands)

According to the projected schedule listed above, the average of distribution ratio from 2006 to 2010 is 95.67%. We set a target payout ratio slightly lower than the average for future uncertainty: 90%. Table 8 shows estimated dividend payments of 2006-2010 using our projected financial statements and that of 2011 - 2020 based on the target payout ratio.

Table 8 Estimated Dividend payments

6. How has Netflix accomplished its growth in the past? With endogenous growth, or with growth by acquisition?

In the past five years, Netflix has mainly accomplished its growth with endogenous growth supported by the fund raised initially by issuing stock.

Table 10 Average number and revenue of paying subscribers (in thousands)

We can see from table 9, the number of total subscribers has an average growth rate of 74.27% during the five years. The increased number of subscribers indicates that Netflix had more and more influence on the DVD rental market as the results of its successful marketing efforts. The money received from the initial public offering was invested mostly in investment activities, such as buying DVDs, computers, and investing in property and equipments. After experienced heavily invested periods, Netflix became profitable in only 3 years.

High reputation for its service has also contributed its revenue growth. Netflix's recommendation technology and the customers' movie ratings enable it to build a deep customer relationship. It continuously adds newly released titles to its library to give consumers more selection of titles. Netflix continually focuses on improving website experience and functionality and seeks to create value-added features for its subscribers. This attracts more paying subscribers to come and enhances the long-term customer's loyalty, which probably generates more revenue. The rapid increase of subscribers attributed to the big increase of the revenue of the company in the past five years.

On the other hand, Netflix has been trying to do its best to lower the operating costs in order to get a bigger profit margin. Netflix utilizes part-time and temporary employees to respond to the fluctuating demand for DVD shipments, which can lower operating costs and meets the demand at the same time. In addition, Netflix always maintains a high level of library utilization which helps it reduce expenditures and enhance the net income.

With these core competencies, Netflix has built the efficient and scalable business model, which enables the company to generate enough free cash flows to support its future operation.

7. Define endogenous growth and growth by acquisition.

Endogenous growth and growth by acquisition describe a manner a company can grow. Endogenous growth means expanding through its normal operations. It is an economic growth whose long-run rate depends on a company's internal behavior and policy. Endogenous growth theory is usually given to the production of new technologies and human capital. Growth by acquisition means growth through a company's external investing activities. Particularly, growth by acquisition can be the process through which one company takes over the controlling interest of another company.

8. How has Netflix financed its growth over the past 5 years? With new short term debt, new long term debt, new equity, retained earnings, or some combination of the above?

At the beginning, Netflix financed its operation by issuing common stock. However, the company generated free cash flow as the result of operating and investing activities since 2003, so that company can finance its growth by internal earnings.

Netflix completed its initial public offering on May 23, 2002 at a price of $15.00 per share. A total of $94,875,000 in gross proceeds was raised from these transactions. After deducting the underwriting fee of approximately $6,641,000 and approximately $2,060,000 of other offering expenses, net proceeds were approximately $86,174,000. Upon the closing of the initial public offering, all preferred stock was automatically converted into common stock. The capital received from the initial public offering supports Netflix in the earlier years.

Netflix has begun to support its operating activities by the cash generated internally since 2003. As shown in Table 11, the net cash inflow from operating activities exceeds the net cash outflow in the investing activities since 2003. It indicates Netflix's ability to finance its growth by its own earnings.

This table provides more accurate measure for the ability to generate cash more than income statement because of the effect of non-cash expenses such as depreciation and amortization which is deducted from net income. In other wards, cash flow statement shows more clearly the company's ability to finance growth by its normal course of business.

9. Support your 5 yr pro forma financial statement.

Forecast Revenues

First of all, our estimation of the growth rate of Netflix begins with analysis of the past five years growth rate of online subscribers because Netflix revenue substantially comes from monthly subscription fees. As shown in Figure 1, the total market has grown from 0.9 million subscribers in 2002 to 8.8 million at the end of 2006.

Figure 2

Source: "Netflix Corporate Fact Sheet" Netflix. 15 April, 2007.

<http://files.shareholder.com/downloads/NFLX/86912410>.

Table 12 shows that Netflix market share from 2002 to 2006. Although Netflix has enjoyed rapid subscriber growth for the 5 years, its market share has decreased from 95% to 75 %. The decrease of market share can be explained by increasing competition. For example, Blockbuster started online service in 2004, and try to eat shares from Netflix announcing their Total Access program, which allows online customers to make a choice between returning their DVDs through mail and exchanging them at more than 5,000 stores for free in-store movie rentals. The rapid growth of Netflix whips companies with large financial resources into the online rental market, such as Apple, Amazon, Wal-Mart, Google and Yahoo!

Table 12 Netflix Market Share

Although the online rental market is expected to experience increasingly intense competition in the next five years, we assume that Netflix maintains 75% market share. The reason for this assumption is Netflix has successfully gained its reputation for high quality services such as a next-day delivery and its catalog 75,000 titles. It also has proprietary software that swiftly sorts DVDs and a strong relationship with various filmed entertainment providers and the U.S. Postal service. Moreover, it responded quickly to a rapid change of the market by launching a downloading service "Watch Now." Therefore, we estimated that Netflix would maintain 75 % market share for the next five years.

However, Netflix may need to decrease its subscription price due to intense competition. It currently offers price packages ranged from $4.99 to $23.99 and the average subscription revenue from a subscriber is $13.60 per month. We estimate the average price will be decrease to $10 per month.

The following table shows estimated subscribers which Netflix will hold each year and estimated revenue from subscription for the next five years.

Estimated Netflix Subscribers is determined based on a market analysis by professional researchers. According to Adams Media Research and Netflix internal estimates, the total market will have more than 20 million online subscribers in the next four to six years. We estimated the total market would have 20 million subscribers in 2010 and 75 % of the total market would be retained by Netflix. Revenue for each year is determined by multiplying a price that a subscriber will pay each year and the average number of subscribers for the year. Therefore our estimated growth rates for the next five years are 46%, 25%, 17%, 13 % and 9% respectively.

Forecast Cost of Revenue

Cost of subscription revenues consists of revenue sharing expenses, amortization of the company's DVD library, amortization of intangible assets related to equity instruments issued to certain studios and postage and packaging costs related to shipping titles to paying subscribers. Fulfillment expenses represent those expenses incurred in operating and staffing its shipping and customer service centers, including costs attributable to receiving, inspecting and warehousing its library. Fulfillment expenses also include credit card fees. Thus, the increase in subscription expenses and fulfillment expenses are primarily attributable to an increase in revenues. We assume that growth rates of subscription and fulfillment expenses are same as the growth rate of revenues from 2006 to 2010.

Forecast marketing expenses

The marketing expenses consist of payroll and related expenses and advertising expenses. They should be decreased as the company attains a nation-wide brand recognition. Marketing expenses are still growing but somewhat at a lower late than other operating expenses, and it will no longer increase or even these expenses can be decreased in future.

Forecast other operating expenses

The technology and development expenses consist of payroll and related expenses the company incurs related to testing, maintaining and modifying its website and recommendation service. They also include depreciation of the computer hardware. The general and administrative expenses consist of payroll and related expenses for legal proceedings, personnel costs and professional fees to support growing operations. The stock based compensation expenses determined under SFAS No.123. The increases in some of those operating expenses are related to the increase in the revenues; however, some of those are fixed in nature. The company has a scalable, low-cost business model designed to maximize the revenues and minimize the costs. As the company continues to expand its business, it is able to leverage operational changes in cost effective manner which further reduces its operating expenses. Therefore, we assume that the growth rates of those operating expenses are lower than growth rates of cost of revenues from 2006 to 2010 as shown in the Table 14. The increase in gain on disposal of DVDs is primarily attributable to an increase in volume of DVDs sold, offset in part by an increase in the cost of DVD sales. Due to this reason, the estimated growth rate of operating expenses is more reasonable as same as growth rate of cost of revenues from 2006 to 2010. Then, we can get the actual and projected operating income statement as shown in Table 15.

Table 14

Table 15

Forecast interest income and expense

The increase in interest and other income is primarily due to higher interest income earned on cash and cash equivalents due to increased interest rates as well as higher average cash balances. However, we assume that the cash and cash equivalents will keep constant with $212,256 from 2006 to 2010 due to the economic structure of Netflix. We also assume that the interest rates will not be changed. Thus, the interest and other income will be as same as 2005 ($5,753) from 2006 to 2010. Based on our assumption that Netflix has no new short-term investments and debts from 2006 to 2010, the company will have the same amount $407 in the interest and other expenses from 2006 to 2010.

Forecast Assets

Netflix must have assets to support the revenues as forecasted on the income statement. Thus, the operating assets typically must also have same growth rate as revenues from 2006 to 2010. However, we assume that cash and cash equivalents will keep the same amount as 2005 from 2006 to 2010, because the company does not need too much money depends on its liquidity position and management's financing policy. The short-term investments, deposits, and deferred tax assets are non-operating assets in the balance sheet, so we assume that Netflix plans to maintain their levels as same as 2005. Under the strategic marketing alliance agreement, Netflix is allowed to use the partner's trademark and logo in marketing the company's subscription services. The Company recognized the fair value of these instruments as intangible assets with a corresponding credit to additional paid-in capital. The intangible assets should be fully amortized on a straight-line basis to marketing expense over 20 years. We can get amortization per year is $24 due to this situation and our assumption. Then, we can get an actual and projected assets statement as shown in Table 16.

Table 16

** Amortization per year = 2005 Intangible assets (net) / 95% / 20 years

Forecast Liabilities

The operating current liabilities include accounts payable, accrued expenses, and deferred revenue. We assume that Netflix use average growth rate 33% between the growth rate of revenues and operating expenses for operating current liabilities, because it involves operating effects driven by both the sales and costs forecasts. Due to this reason, even though deferred rent is not operating current liability, it should be use 33% growth rate to forecast. The other liabilities and stockholders' equity will be influenced by management's financial policy decisions. However, in this case we assume that Netflix will maintain its current level in 2005 from 2006 to 2010. Then, we get actual and projected liabilities financial statement as shown in Table 17.

Table 17

** The process of projected retained earnings from 2006 to 2007 is illustrated in Table 16.

Forecast retained earnings

According to dividend policy of Netflix as discussed in the question 5, it will begin to pay dividends from 2006. Therefore retained earnings increase each year by the difference between net income and dividend payments as shown Table 18. Based on our estimates, retained earnings will turn positive in the year 2014.

Forcast Cash Flow

Cash flow for 2006 - 2010 was projected based on information from our estimated balance sheet and income statement. Depreciation of property and equipment, which must be added back in a cash flow statement, is estimated from the following table.

Table 19

We calculate 2006 depreciation by adding total purchase during 2006 to 2005's P &E net amount, then subtracting 2006's P&E net amount from that number. Amortization of DVD library is determined in like wise from the following table.

Table 20

We could obtain more detail information for intangible asset. Based on information we got from the annual report of Netflix, the intangible asset are amortized by $24 over the next 20 years. Since there is no acquisition of intangible asset for the next five years in our estimation, the figures for the beginning and ending Intangible assets, amortization, and acquisition are as shown in Table 21.

Table 21

In a word, the 5 yr pro forma financial statements are subject to risks and uncertainties that could cause actual results and events to differ, including, without limitation: impacts arising out of competition, Netflix's ability to manage its growth, in particular, managing subscriber acquisition cost as well as the cost of content delivered to its subscribers; its ability to attract new subscribers and retain existing subscribers; changes in pricing, availability and effectiveness related to its advertising; fluctuations in consumer usage of its service, customer spending on DVDs and related products; disruption in service on its website or with its computer systems; deterioration of the U.S. economy or conditions specific to online commerce or the filmed entertainment industry; conditions that effect its delivery through the U.S. Postal Service, including regulatory changes and increases in first class postage; increase in the costs of acquiring DVDs; and, widespread consumer adoption of different modes of viewing in-home filmed entertainment.

10. What do you expect the long run growth of Netflix to be, beyond the next five years?

As discussed before, we assumed that Netflix would maintain 75% of market share for the next five years. We continue to assume that Netflix will maintain 75 % of market share after 2010 because of its quick move for a downloading service and its high reputation for its service. Figure 3 presents our estimation of the number of subscribers for the total market and Netflex beyond the next five years.

Figure 3

We estimates that the maximum total market will have 25 million subscribers and the market will reach the maximum by 2015; therefore, Netflix acquire 18.75 million subscribers by that year. Even after the market becomes mature, the company will be able to enjoy revenue growth enough to afford the 5 % dividend growth. Netflix has a scalable, low-cost business model which able to reduce its operating costs on a per subscriber basis. Once Netflix establishes strong national brand recognition, it can reduce marketing cost significantly. Increased automation by its proprietary technology, vendor negotiating leverage, and online interface also allow Netflix to enjoy economies of scale. Moreover, Netflix has flexibility since it does not own any real property. It enables the company to respond quickly to rapid change with the least cost. All of these facts support future Netflix growth beyond the next five years.

11. What would you pay for this stock?

The value of a share of the stock is the present value of the expected dividend stream which Netflix will produce. According to the future dividend payment which is estimated in the question 5, the value of a share of the stock of Netflix is calculated as follows:

First, dividend payments are projected as follows (see also Table 8.)

D1 = 1.1313

D2 = 1.5431

D3 = 1.9343

D4 = 2.2659

D5 = 2.6058

D6 = 2.9446

D7 = 3.2685

D8 = 3.5626

D9 = 3.8120

Secondly, a present value of dividends is calculated by discounting at the required rate of return, 15.75%, which is explained later.

PV D1 = $1.1313 (PVIF15.17%1) = $1.1138

PV D2 = $1.5431 (PVIF15.17%2) = $1.1517

PV D3 = $1.9343 (PVIF15.17%3) = $1.2473

PV D4 = $2.2659 (PVIF15.17%4) = $1.2623

PV D5 = $2.6058 (PVIF15.17%5) = $1.2541

PV D6 = $2.9446 (PVIF15.17%6) = $1.2243

PV D7 = $3.2685 (PVIF15.17%7) = $1.1741

PV D8 = $3.5626 (PVIF15.17%8) = $1.1056

PV D9 = $3.8120 (PVIF15.17%9) = $1.0220

PV of dividends = $10.5552

Next, a horizontal value is determined by the constant growth formula given 5% growth rate ( g = 0.05; see also Table 8).

^

P9 = 3.8121(a +0.1575)/ (0.1575-0.05) = $37.2344

Since this value is the price of the stock 5 years from now, it should be discounted back nine years.

^

PV of P9 = 37.2344 (PVIF15.17%9) = $9.9829

The value of the stock is sum of the present value of dividends and the present value of the horizontal value.

In conclusion, we are willing to buy stock of Netflix if the price is less than $20.54.

Estimation of rs under CAPM Approach

We estimated the required rate of return for the stock of Netflix under CAPM Approach by using the formula: rs = rRF + (RPM) bi

rRF = 4.73%.

We use the yield on a 10 year T-bond for the risk-free rate. According to Financial Forecast center, the rate for a 10 year T-bond is currently 4.73%.

RPM = rM - rRF = 5.54%

rM is determined by the formula; [D0 (1+g)/ P0] + g. The web site "Returns" calculated the average dividend yield and Dividend 5 year growth rate for the S&P 500 stocks.

Current Dividend yield (D0)/ P0) = 2.15%

Dividend 5 year growth rate (g) = 10.89 ("Ratios" 1)

Based on the above information, rM is calculated as following;

rM = [0.0215(1+0.1089)] + 0.1089 = 0.1327

RPM = rM - rRF = 13.27% - 4.73% = 8.54%

This historical average return will be too high, so it should be adjusted downward by 3%; RPM = rM - rRF = 8.54 - 3 = 5.54%.

bi = 1.99

Beta for Netflix can be found on the Google finance ("Netflix, Inc" 1).

Therefore, the required rate of return is 15.75% determined by the following formula;

rs = 4.73% + (5.54%) 1.99 = 15.75%

12. What is the greatest threat to the future of Netflix?

Many factors increase uncertainty about Netflex's future business. The top three threats are a recession, intense competition, and a major technology change such as a destructive innovation. First, Netflix is vulnerable to economic downturn as its high beta indicates. During a slack time, a customer first try to save money by stopping unnecessary expense such as a DVD monthly subscription payment. Moreover, it would be hard for Netflix to attain a number of new customers to support its growth in such a time. Secondly, it is foreseeable that companies with large resources will enter the online rental service market because of the Netflix's rapid growth in the past seven years. Some of them might try to beat Netflix with aggressive pricing policies. Intense competition may force the company into a substantial price cut off, which will decrease its profitability.

Finally, a destructive innovation in the market might make DVD obsolete, which requires Netflix to raise a large amount of money to respond the change. Another threat is that VOD technology would prevail in the rental service market as high-speed Internet access increases. In that case, other companies such as digital cable providers and Internet providers might perform better than Netflix does because they have more experience and expertise in this area.

13. What is the greatest opportunity for Netflix?

In order to keep growing, Netflix must find opportunities because the U.S. market for the online DVD rental service will be saturated in the next 10 to 15 years. Two opportunities can be the greatest opportunities for Netflix. First opportunity is to expand its operation into another country. U.K. and Canada will be less risky to enter because of location and language. Moreover, an online downloading service makes its business geographically borderless, which gives the company a huge potential to grow. Secondly, Netflix can add another complementary service to the existing DVD rental service. Since Netflix currently maintains more than 6 million subscriber's accounts, adding another service will bring the company considerable amount of revenue.

14. If Netflix is projected to generate free cash flow, explain what you would do with the excess cash, and why.

Netflix produces a large amount of free cash flow resulting from its efficient operation. The following table describes how the amount of free cash flow was projected.

Table 22 Free Cash Flow from Netflix Operation (in thousands)

Free cash flow can be used to pay interest to debt holders, pay off some of the debt, pay dividends, repurchase stock, or buy marketable securities. Paying interest and paying off debt are almost irrelevant to Netflix, because it does not have any note payable and long-term debt. Since free cash flow should not be retained by management unless it can generate higher returns than shareholder could earn by investing that money in equal risk investments, paying dividends or repurchasing stock is the most effective way to maximize a shareholder's wealth. Following Netflix dividend policy discussed in the question 5, we assume that paying dividends to its shareholders would be the best way to maximize its stockholder value.

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WORKS CITED

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"Netflix Corporate Fact Sheet" Netflix. 15 April, 2007.

<http://files.shareholder.com/downloads/NFLX/86912410>.

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