How to Value Companies like Netflix?

Netflix is one of the largest providers of content in the world. This is amazing given the fact that content is free on the internet. People can go to websites like YouTube and entertain themselves for free. Netflix has built its business in such a hostile market. The customer base seems to be very loyal, and revenues seem to come in like clock-work. However, subscription-based businesses like Netflix present a complication for investors. These businesses have a different model. Hence, investors find it difficult to put a price tag on them. In this article, we will discuss the basics of valuation with regards to companies which are selling subscription based products like Netflix.

Firstly, we need to understand the importance of subscription-based model businesses. They have been growing at a mind-boggling rate of 200% since the year 2011. At the present moment, close to 12 million people in the United States are users of some form of subscription service. Earlier this model was used by products like newspapers, gym services, etc. However, of late, this model has been applied to a wide variety of products and services. Entertainment content, music, beauty supplies and even personal hygiene products are being sold via this model.

The fast growth of subscription-based businesses does not mean that every company is succeeding. There are some companies like Netflix which are growing by leaps and bounds. However, close to 15% of all start-ups in this area are going broke within the first year. This is the reason why investors need a specialized set of metrics to understand and evaluate this new business model.

Cost of Customer Acquisition

Subscription-based businesses do not do well if the initial cost of customer acquisition is too high. A high customer acquisition cost coupled with high competition can spell doom for the business. Companies like Netflix have a relatively simple customer acquisition model. They allow the users to use their services for one month without levying any fee. This provides value to the customer. However, the cost to the company is negligible. Netflix doesn’t have to spend any additional money to serve one extra customer! Netflix seldom offers any other sales promotions. The money spent on advertisements is also quite small. A lower cost of customer acquisition speaks volumes about the content that is being offered. It is only because Netflix offers good content that people who take the free trial end up becoming paying customers.

Stability of Customer Base

A high churn rate is an anathema to a subscription-based business. This is why companies like Netflix often publish statistics about their customer base along with their financial reports. Investors like companies which have a relatively stable customer base. Hence subscription-based companies often divide their customer base into segments like customer since ten plus years, customers for five plus years and so on.

Maintaining a stable base means that the company ends up earning stable monthly recurring revenue. This is vital to a subscription-based company where revenues can be seasonal and erratic.

Also, the stability of customer base is an indication of the quality of the content. If the content is not good, the churn rate will inevitably rise. This makes it difficult for the company to grow. The marketing department works hard to obtain more customers. However, if the churn rate matches the growth rate, the company will be no better off! Eventually, the churn rate will increase and the company will experience an erosion of revenue. It is for this reason if any subscription based company has a higher churn rate than its peers it immediately needs to focus on its content.

Upselling and Cross-Selling

Upselling and cross-selling are important sources of revenue for any subscription based company. For instance, Netflix provides packages where the content can be viewed on multiple devices. The marginal cost for the company is nil. Hence, they give huge discounts to customers who decide to use the service on multiple devices. As a result, different people in the family can enjoy the service at a lower cost. For Netflix, the Average Revenue per User (ARPU) tends to go higher when such service bundling is done. The rate of cross-selling and upselling gives the investors an indication of the stability of the business. Cross-selling and upselling have a negative correlation with the churn rate making it even more beneficial for subscription-based businesses.

Time Spent Using The Service

Companies like Netflix tend to monitor the activities of their customers. They do so to understand the popularity of the content being viewed. This allows them to create more content which is liked by the customers. Also, time spent on the website by the customers is a leading indicator of the revenues for the forthcoming period. Customers only pay if they genuinely use the service. Hence, if some customer accounts are dormant for long periods of time, they are unlikely to renew and this may hit the revenue. Measuring the frequency and time spent using the service is also the best way to guess the probability of upgrades. This data is often included in the financial reports since it allows the investors to make an educated guess about what the revenues of the company will be in the forthcoming periods.