According to Warren Buffett, there are three things that an investor should look for when evaluating a stock or a company. The first is a strong business. The second is an advantage over its competitors. The third is a reasonable price.
Shares in Netflix (NASDAQ:NFLX) have been falling this year. But the company has the largest subscriber base of any of the streaming providers and it outperformed expectations this week in terms of revenues and earnings. So does Netflix meet the Warren Buffett criteria?
A strong company
According to Buffett, the best type of business is one that is able to grow its earnings without having to invest much in order to do so. That means that the cash that it produces doesn’t have to be reinvested into the business.
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A good example of this kind of business is Rightmove. The company doesn’t own much in the way of physical assets — it has no shops, no factories, and no substantial equipment. That means that when it makes money, it doesn’t have to be used in maintaining these assets.
I don’t think that Netflix is a great example of what Buffett would think of as a wonderful business. While it’s true that the company doesn’t have to spend much to distribute its service to more people, it is almost constantly spending to acquire and develop new content.
A competitive advantage
The best companies also have something that prevents competition from stealing their customers. This can come in various forms — it might be that it’s hard for customers to change, or that the company’s products are protected by patents.
The London Stock Exchange Group runs the exchanges that financial transactions take place on. There’s little incentive for anyone to try and compete with them in the UK, because their market position is so dominant and it would be expensive for a competitor to get set up.
In the case of Netflix, I find it hard to see where a competitive advantage comes from. Worse yet, Netflix now seems to be competing with a lot of other players, such as Amazon, Apple, and Alphabet. Having to try and fend off competition with deep pockets is undesirable in my view.
Price
Price is important when it comes to investing. Arguably, the reason that Netflix shares have fallen so precipitously is that the share price was too high in the first place. But has the company’s share price fallen to a reasonable level?
At the time of writing, Netflix stock trades at a level that implies a price of just under $100bn for the entire organisation. The business has around $6bn in cash and just over $15bn in debt, giving an overall valuation of around $109bn.
Last year, Netflix produced around $6.2bn in operating income. That’s a return of around 5.7%. I think that’s a decent return for a company that has the capacity to grow its earnings in the future. From a price perspective, I think that there’s reason to think that Netflix shares are attractive.
Conclusion
The recent drop in Netflix stock has brought shares to attractive levels. But I think that the underlying business isn’t one that I’d like to own. That’s why I don’t think I’ll be buying Netflix shares, even at these prices.
