Sensitivity Analysis

The forecasted variables in the forecasting are uncertain as they are chosen based on our judgments and insight from the strategic analysis. Several assumptions influence the computed DCF value, and by conducting a sensitivity analysis, we uncover how different outcomes of the independent variables will impact the value of Netflix. We have decided to study the variables WACC, terminal growth, tax, amortization, and revenue. The table below summarizes the sensitivity analysis:

Table 8.3: Sensitivity analysis, with new values as a percentage of old

WACC Value Terminal growth Value Tax rate Value Change in other operating expenses Value Change in content costs Value Change in revenue growth Value

8.70% 114.0% -3% 110% 3% 106% -2% 110% -1% 110% 1% 118%

9.19% 106.8% -4% 105% 5.25% 103% -1% 105% -0.5% 105% 0.50% 109%

9.67% 100.0% -5% 100% 7.51% 100% 0% 100% 0% 100% 0% 100%

10.15% 94.0% -6% 96% 9.75% 97% 1% 95% 0.5% 95% -0.50% 92%

10.64% 88.3% -7% 93% 12% 94% 2% 90% 1% 89% -1% 84%

8.1.0.1 WACC

We have applied a WACC of 9.68 % in our calculations. Looking at the different variables of the WACC, we find it reasonable to exercise a WACC in the interval 8.70 % - 10.64 % depending on the changes in Beta, the risk-free rate, the market premium and the cost of debt. As we can see from the table, the components in the WACC are particularly uncertain and of high importance in the model. Since Netflix has a high equity ratio in the WACC, the components in the equity cost of capital will have a more significant impact on the value. Further, we predict that the debt will increase the first years and after that decrease, resulting in changes in the capital structure and consequently changes in the WACC.

8.1.0.2 Terminal growth

In our DCF valuation, the terminal value represents 68.56 % of the equity value, and changes on in the growth rate will, therefore, have significant implications on the value estimate. Based on the strategic

and financial analysis, we believe that the growth rate will be negative in the terminal period based on high competition and rapidly changing industry. We find it reasonable that the interval will be between -3 % and -7 %.

8.1.0.3 Tax

Netflix is mostly affected by the American tax rate, which could be lower or higher in the future; we have also used a weighted average effective tax from the historical period when forecasting. However, the effective tax rate changes every year and have been quite volatile during the historical period and is consequently hard to predict. Accordingly, we believe that the effective tax rate can be in the interval of 3 % - 12 %.

8.1.0.4 Other operating expenses

Other operating expenses are substantial costs for the firm, including marketing, technology and development and general and administrative costs. Even though general and administrative costs will be relatively stable, marketing and technology and development are more industry dependent and may, consequently, fluctuate more. We will use the interval -2 % - 2 % of the current percentages of revenue in order to see the impact a change in the costs will have on the equity value.

8.1.0.5 Content Costs

Content cost is the largest cost for Netflix and will therefore heavily affect the equity value if it changes.

It is uncertain how these costs will change since the costs are highly affected by future competition and the financing of the firm. We will apply the interval -1 % - 1 % of the current percentages of revenue in order to see the effect that a percentage will have on the equity value.

8.1.0.6 Revenue

Revenue is one of the most important determinants in the DCF. Consequently, adjustments in the forecasting of the revenue will change most of the other variables as we have used a sales-driven approach in the DCF valuation. Revenue can fluctuate depending on different macroeconomic factors, where subscription price and subscription growth is the most important. These factors will vary based on the competitiveness in the industry and the attractiveness of the products that Netflix delivers. We will use the interval -1 % to 1 % of change in revenue growth to see how a percentage change impacts the equity value.

9 User-Based Valuation (UBV)

To start our pricing of users correctly, we will begin with a framework for valuation. A. Damodaran (2018a) has developed a framework existing of three sections. The framework will be used to value both existing and new users. Firstly, we will conduct the value of an existing user, and avail ourselves of this to value all existing users. Secondly, we will value all new users, by subtracting the cost of adding a new user and combining this with estimates of the number of new users added in future periods. Thirdly, we will extract the expenses that are indispensable to business existence but unrelated to users, to find the total value of the user-based company.

V alue of a user−based company=V alue of Existing U sers

+V alue of N ew U sers−V alue of Corporate Drag (9.1)

We will not focus on the DVD segment in this valuation since it is expected that the segment will decrease for the next three years and afterward be excluded from the service. However, the value of existing user includes the DVD segment for the next three years, since the segments are still profitable and adding value to the firm.

9.0.0.1 Drivers for the user based valuation of Netflix

There are several drivers with a significant impact on the value estimate of Netflix. We will cover the trends of these as a starting point, and with the combination of the assumption in the forecasting section, we will forecast future performance for our user-based valuation.

9.0.0.2 Monthly fees

From the strategic analysis, we saw that Netflix has a significant focus on its content library, and on using Big Data to tailor its content to the individual consumer. This advantage will allow Netflix to raise its monthly fees without losing much of its customer base to cheaper services.

Figure 9.1 displays the change in the price of Netflix’s Standard Plan. The price has remained at

$10.99 throughout 2017 and 2018, but in January 2019, Netflix decided to raise its price by $2. This price increase is the highest increase since the service launched. Netflix’s current success in content production has increased its brand value and has made its service unique. This advantage allows them to raise their monthly fees in the short term without a high loss of customers.

Figure 9.1: Price Development of Netflix’s Standard Plan

Source: Own contribution using data from Statista

9.0.0.3 Renewal rate

The existing customers of Netflix represent a great deal of their value, and a high renewal rate is crucial for the firm to succeed. A challenge Netflix faces is the fact that the cost of switching services is very low. Simultaneously, there is a threat of pirate copying, and new competitors stealing market share. There is no annual contract, and the cost of signing up for the service is minimal. Furthermore, consumers have access to a great deal of information about the different services, and they can compare services and platforms based on online information. Because of this, Netflix needs to give the customers a good experience for them to remain at their service. Customers expect products which are tailored specifically for their demands, and this might also be a way for Netflix to differentiate its service. The use of Big Data to personalize its service towards the customers might help them keep the customers from substituting their subscription for other competitive services. The ease of using Netflix, where the service already knows the people’s content preferences and adapt accordingly, can maneuver subscribers into staying on their platform, especially in the short term.

9.0.0.4 New members

The advances in mobile, video and wireless technologies have led the popularity of streaming services to continue cultivating. Streaming video-on-demand and over-the-top (OTT) subscriptions are one of the fastest growing components of the video ecosystem, and more than 60% of US consumers (and 82% of millennials) stream TV shows at least monthly (Deloitte, 2019). Experts predict that video streaming will account for 80% of all internet traffic in 2019 (Roshan, 2018). This opportunity enables Netflix to

expand since there is significant potential in acquiring new customers. From the subscription analysis, we learned that Netflix had an average annual subscription growth of 24.7% from 2014 to 2018, ending with 139.26 million subscribers in 2018. Netflix has furthermore succeeded in expanding at a much higher rate than HBO, where we predict that this trend will continue in the future.