We think in terms of stories and analogies. We were born to do it. In Sapiens, Yuval Noah Harari argues that our penchant for telling and believing in stories is the “mysterious glue” that allowed humans to cooperate and dominate the world.
While stories may encourage cooperation, they can sometimes blind us to reason. Daniel Kahneman illustrates how stories can breed fallacies in Thinking: Fast and Slow.
He describes an experiment involving a fictional woman named Linda. In the experiment, Kahneman and his partner Amos Tversky described Linda as a young, single, outspoken, brilliant philosophy major “concerned with issues of discrimination and social justice, [who] also participated in antinuclear demonstrations.”
They then asked people which was more probable:
(1) “Linda is a bank teller.”
(2) “Linda is a bank teller and active in the feminist movement.”
They found that “85% to 90% of undergraduates at several major universities chose the second option, contrary to logic.”
We can be so willing to take a narrative, form a mental picture, and categorize things that we set aside reason.
The same thing can happen when discussing businesses, and few companies are as well discussed as Netflix. In a recent appearance, CNBC guest David Trainer argues that Netflix’s valuation is “disconnected from fundamentals.” He claims that that investors “seem to be unbelievably gullible these days,” and that Netflix is a “story stock.” Trainer mentions profit margins and multiples to suggest that Netflix is hugely overvalued, and explains that investors are falling victim to a false narrative.
But which is the false narrative? Although Trainer derides Netflix as a “story stock,” isn’t he constructing his own story here? He seems to apply a standard valuation framework, compares Netflix to other content creators like Disney, and posits that it’s “a tough business to be in”. He asks, “can you name any businesses in the history of the world that have consistently [sic] created profitable new content?” The framing of that question sounds suspiciously close to a story.
The problem with this way of thinking is that some businesses have predictable economics and some have highly uncertain economics.
In an electric utility, for example, we can be somewhat confident in forecasting future cash flows. We might look at population trends, trends in energy consumption, and the utility’s cost per watt. The industry is highly regulated, so utilities have limited ability to increase margins. Given those constraints, if we try to place a value on XYZ Utility, maybe we’ll say it’s worth $1 billion, or maybe it’s worth $1.2 billion, but it’s definitely not worth $10 billion. With this type of business, we could use multiples or industry comparables and feel pretty good about our estimate of value. It’s a fairly predictable story.
With a business like Netflix, the future is incredibly uncertain. We do not know what its programming content will cost in ten years or how much pricing power it will have. We don’t know what its innovations will be. Trying to use a quantitative approach like discounted cash flow or even comparables to value this type of business is fraught with danger.
So why might Trainer be wrong? Why might the market think Netflix is worth $60 billion?
Consider what the business is, who runs it, and what it could be in ten years. The company is building a massive stream of recurring revenue with sticky subscribers. It has an innovative team. We can see the trends in cable vs. streaming, and we can imagine a future in which Netflix could raise prices without losing many subscribers. A business with almost no need for physical capital has the potential to send additional revenue directly to the bottom line. Netflix might not live up to lofty expectations, but there is something real here. Maybe investors aren’t just being “gullible.”
Sometimes, using a valuation formula or comparables can be dangerous. To quote Seth Klarman, “Any attempt to value businesses with precision will yield values that are precisely inaccurate.” We should be skeptical of any stock that has a sky-high valuation, but we should also be skeptical of valuing a business by formula or by analogy. Valuing a business like Netflix is like looking through fog. If you’re looking through fog for land on the horizon, don’t use a magnifying glass.
Disclosure: I do not currently own shares in Netflix.