Valuing Stocks 101

Patrick Badolato is a professor of accounting at the University of Texas at Austin’s McCombs School of Business. He joined Motley Fool host Ricky Mulvey for a conversation about how to value companies.

They also discuss:

• How to put P/E ratios in context — and how to look beyond that metric.
• Levers Walmart could pull to double its earnings.
• Growth stories for Netflix that go beyond subscriber count.

Go to breakfast.fool.com to sign up to wake up daily to the latest market news, company insights, and a bit of Foolish fun — all wrapped up in one quick, easy-to-read email called Breakfast News.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our beginner’s guide to investing in stocks. A full transcript follows the video.

This video was recorded on Nov. 16, 2024.

Patrick Badolato: No, price-earnings multiple is like a beginning, one beginning, one very useful reference point to think about what the company is, what they’re worth, what the market is valuing that at the moment, and so with that lens, it’s the starting point to valuation. Hey, why is? It’s the starting point for these conversations. Why is it or what is the market pricing? Why is it that the priced earnings ratio would be higher than average? Are there fundamental reasons related to the company’s performance that’ll be less than the market average? It’s the starting point where we can start to flesh out those conversations about companies.

Mary Long: I’m Mary Long, and that’s Patrick Badolato. He’s a professor of accounting at the University of Texas at Austin’s McCombs School of Business and a return guest on Motley Fool Money. My colleague Ricky Mulvey caught up with Badolato for a conversation about how we put a price tag on companies. They also discuss by PE ratios, get a bad rap, and how to make that metric more useful, the value lovers that Walmart could pull to double its earnings and Netflix’s expansion opportunities beyond subscriber growth. [MUSIC]

Ricky Mulvey: Patrick, I know why financial analysts want to spend time building cash flow models and why accountants are able to use this language to communicate valuations but why should regular retail investors that are investing a couple hundred bucks in the stock market every month, why should they spend the time valuing the companies that they own?

Patrick Badolato: That’s a great question, Ricky. I think one of the main reasons just that whether we’re doing it directly or not when we’re making an investment, we’re giving an opinion about what we think about the value of the company and at the most basic level, if we’re going along and buying a stock, we’re saying that we expect it to go up or go up better than other alternatives and so that in and of itself is valuation, that’s not necessarily all of the specific modeling that happens in the professional world but still, you’re making an investment in stock, you’re doing valuation.

Ricky Mulvey: I want to get into ways because you have a couple of LinkedIn posts about how this can be simplified, and I ran through it with Netflix, and we’ll hopefully get to that a little bit later in the show but I thought you brought up one idea that seems interesting, which is “the output or value we expect to get out of something is a function of what we put in on a recurring basis.” Valuation fits into this idea, and we often think about it in terms of nutrition, practicing a fine motor skill, exercise, that thing but let’s take that away from the human achievement part. How does valuation fit into that idea?

Patrick Badolato: Great. I actually really try to in communicating this material to students, always make sure that there’s a human element to it. I’m glad we started there. But let’s tie that to valuation. The general idea of multiples is really the essence of what you’re describing. When we think about it mechanically, we’re going to have a numerator, the value or the output we expect, and then a denominator, which is the thing, the aspect of the company that’s going to be on a recurring basis, whether that would be something like earnings or if you’re looking at cash flows or whatever else, what’s the output? What does the company do on a recurring basis? Then the value of a company, whether it’s the total value of the company or the value per share or whatever else, should definitely be a function of what that company does on a recurring basis or what we expect that company to do on a recurring basis.

Ricky Mulvey: If you expect that to grow a lot, you’ll put a higher value on that, a higher price tag on it, similar to let’s say, maybe you expect greater results from someone who is extraordinarily committed to exercise or extraordinarily committed to playing the guitar 2-3 hours a day versus someone who perhaps is less committed to playing the guitar, watching a three minute YouTube video once every other week.

Patrick Badolato: Yes, that’s perfect. Exactly.

Ricky Mulvey: Let’s try to make this easier, though, because valuation can be intimidating. Once we start opening the Excel spreadsheet, things can get a little bit dicey for us, retail investors, Patrick. Let’s try to make it easy. How can we use historic market averages to make valuation, to make valuing companies a little bit easier for us?

Patrick Badolato: I think right now, Ricky, it’s probably worth just mentioning that the mechanism or one of the forms of valuation, I think, might be useful for any investor, professional retail, just to start thinking about valuation is the PE multiple, which is price to earnings or the stock price of a company relative to its earnings per share and that’s just a starting point and if we’re thinking about price to earnings, one of the things we can do is just a general reference point. Is to just look at what have price to earnings ratios been across the economy, across time, or the last 30 or 50 years and generally speaking, they hover around 18-20%, so that is not the completion of valuation, but once we start talking a little bit more about price to earnings ratios, I think the first reference point is just okay, so in general, how has the market priced most stocks relative to earnings across time? That’s roughly 20 times or the stock price is going to be 20 times each annual amount of earnings per share that that company can create.

Ricky Mulvey: Some companies are able to maintain a much higher price tag for an extraordinarily long period of time. We can think about a company like Disney, which despite its recent issues with leadership questions about streaming, that thing for a long time, it’s traded above a higher than a 20 times earnings price tag and then you can also think about some manufacturing companies.

I’ll throw General Motors under the bus here, that have traditionally traded a lot of these car makers lower than the traditional market average but this, I think it’s a good starting point for investors, I’m going to break away from the outline I gave you earlier. This is on purpose. Price earnings to earnings multiples often get a bad rap because it doesn’t I’ve heard investors say it doesn’t really tell you anything because for young companies, they’re inscrutable and there’s so many adjustments that companies can make to their earnings to make them appear better than they are. That’s a cynical take, but do you think the price to earnings multiple is deserving of the bad rap it gets from some of those on I’ll blame FinTwit?

Patrick Badolato: I actually first want to somewhat agree with that and then also disagree. I would say first, I would agree with the criticisms to be clear, I guess, agree with the criticisms in that using a price to earnings multiple is not completing valuation and when we find one company that’s significantly lower than average or significantly higher than average, I just want to very aggressively caution, that’s not the answer, that’s not valuation. We cannot say that this company is trading at only 10 times earnings, therefore, it must be undervalued because that’s less than the average or another company that’s trading at 40 or 30 times earnings must be overvalued. I think that’s a huge flaw of thinking of a price to earnings ratio as the end result evaluation.

Rather, I want to emphasize that no, priced earnings multiple is like a beginning, one beginning, very useful reference point to think about what the company is, what they’re worth, what the market is valuing that at the moment and so with that lens, it’s the starting point to valuation. Hey, why is? It’s the starting point for these conversations. Why is it or what is the market pricing? Why is it that the priced earnings ratio would be higher than average?

Are there fundamental reasons related to the company’s performance that will be less than the market average? It’s the starting point where we can start to flesh out those conversations about companies, so that’s where I would say using it as the end result, I want to agree with the criticism, that’s going to be flawed, that’s really not the point but disregarding it because of that, I think would also be going too far. If I can jump in just to keep this conversation going, I think the other comment you were making was more about, hey, but aren’t there flaws with earnings, and wouldn’t that be an incremental reason or challenge to using a price to earnings multiple if the denominator is something that we might find flaws with or tend to criticize. And I’d argue we do have to be careful with earnings, we don’t just want to accept that as, just because it’s reported, everything’s good and representative, but at the same time, the fact that there could be issues is less of an issue because we’re not really saying valuation is done given a price to earnings ratio, what we’re really trying to figure out is, where will their earnings go and how will price move alongside those earnings?

Those shouldn’t be based on even what the company’s doing alone, it should be our own forecast of how we think the company should do going forward. The earnings that we ultimately care about when we’re building valuation, whether it’s a massive discounted cash flow valuation model or using a multiple, whatever else, it’s still based on our projections of what we think will happen.

Ricky Mulvey: I have this price to earnings multiple for a company, this point in time, the price tag that investors have given to a stock. What are some places that investors should look next if they’re saying, is this thing undervalued? Should they be looking at revenue projections, should they be looking at historic price to earnings multiples to see what this company has done in the past? Where should they look?

Patrick Badolato: Yes, I think the first thing is to repeat your point. First just figure out right now, what is the PE ratio for the company? What do I think about that? How’s it compared on average? Second thing I would start doing is just making sure that your denominator, your earnings is representative, and the term I use is just the idea of core earnings, so in the denominator, you want to make sure that the price to earnings ratio is not too high or too low, simply because earnings for that particular period or the trailing 12 months are non-representative.

For example, there was a large one time gain or a large one time loss or something like that, that is included in earnings or net income, but just naturally wouldn’t be a recurring event. The first thing I would say is just understand what we’re looking at right there in that moment in time to your point, Ricky our earnings representative and if not, I would say, we can just adjust out the items that we think are truly one time or truly non-recurring. Again, not to complete valuation, but to make sure that our initial reference point is a valid one.

Ricky Mulvey: That could be something like a company has made an acquisition that they paid a lot of money for. I’ll use Lululemon with the mirror acquisition, and then they have to write down that acquisition, and then you see adjustments to a company’s earnings.

Patrick Badolato: Yes, in that particular case, I would say it’s the period of the write down would be the one that has a little bit of a wonky impact on the earnings, not actually necessarily the period of the acquisition itself. The acquisition would change the financials, but wouldn’t necessarily change their earnings in the period of the acquisition.

Ricky Mulvey: What we’re trying to bring this back to when we think about valuation in a company’s earnings and if it’s undervalued, overvalued, if you buy stock, if you’re trying to think about a company’s value drivers. What are the things driving the value of this company? It’s a fundamental question, but how can investors think about value drivers for companies?

Patrick Badolato: I think that’s really where we want to spend our time. So far, we just talked about getting a reference point and everything else, we want to spend our time on figuring out the value drivers and ultimately, valuation conversations about companies. This doesn’t extend all asset classes but companies is a conversation on revenues, expenses, and then risk. Let’s focus on revenues and expenses. What are your main drivers of performance, your main drivers of cash flows or earnings, the revenues and expenses, how can those things drive value? Well, we’re trying to figure out what could drive revenue? What’s the ways that it could grow over time? Then expenses aren’t really the driver of value. The driver of value would be margins and so the way we can think about that is okay, so how can my expenses change in relation to revenue such that I could get margin expansion or possibly, another way, margin contraction. The biggest part of valuation is doing our best to figure out what would drive revenue going forward and how do expenses work alongside that? Do we have opportunities for economies of scale, do we have opportunities for margin expansion, and what would be the reasons behind that?

Ricky Mulvey: Why not spend a lot of time thinking about risk then? You said, it’s revenue, expenses, and risk.

Patrick Badolato: Oh, sorry, I didn’t mean to downplay that is don’t think about it. I would argue, though, that the risk conversations are extremely important but in some ways, they can actually be weaved into, and this is hard to do because we’re going to get pretty qualitative here right now for a second but your risk conversations can be woven into conversations on revenues and expenses. What are the risks the company faces? Well, one of the main ones is that revenue won’t be as big as expected or as big as the capital they’ve deployed, or it won’t be big enough to cover their expenses such that they operate at a deficit in terms of revenue being less than expenses, which could translate to an inability to generate enough cash flow, so risk is extremely important, but risk really is, how is the company going to perform in its core business?

It’s revenues relative to its expenses over time, so certainly worth considering. Hopefully, when we’re looking at our projections of revenues and expenses, we are thinking about, I guess, first and foremost, what could go wrong and why? What are the additional threats and competition that could come in and change this? Then also, what mistakes could we make, what are we overlooking? What other aspects could enable our projections to not turn out the way that we are expecting or maybe a rosy picture that we’re hoping to present?

Ricky Mulvey: I think that’s also the case to build multiple scenarios in a lot of ways, so a lot of times with risk as well, and for companies, it can be geopolitical, so we think about EV makers right now, Nissan recently reported today saying, we didn’t sell as many electric vehicles in China as we expected. You might see some of these geopolitical battles playing out, it’s hard to model. If you’re thinking about a company like Taiwan Semiconductor, yes, it supplies the world with microchips, but also you have a geopolitical risk between Taiwan and China, and that can be intensely difficult to predict within an Excel spreadsheet. I want to boil this down. When we think about the Standard & Poor’s 500. If someone’s just buying an index fund, what are the fundamental value drivers for the Standard & Poor’s 500?

Patrick Badolato: In general, if you’re making an investment in equities a standard point, a general market index, you’re expecting that the economy will grow and the companies that represent that index are going to grow alongside the economy and so that growth is going to include inflation, it’s just going to include that companies overall will continue to perform, we’ll have some rent earnings growth. We’ll be able to grow alongside the economy, so that’s just a starting point that an investment in equities does involve an expectation of growth, it’s not just I’m going to make my investment to preserve my capital. I’m doing so with some risk and some expectation of return.

MALE_1: Creators of the popular science show with millions of YouTube subscribers comes the Minute Earth podcast. Every episode of the show dives deep into a science question you might not even know you had but once you hear the answer, you’ll want to share it with everyone you know. Why do rivers curve? Why did the TRx have such tiny arms? Why do so many more kids need glasses now than they used to? Spoiler alert, it isn’t screen time. Our team of scientists digs into the research and breaks it down into a short entertaining explanation, jam packed with science facts and terrible puns. Subscribe to Minute Earth wherever you like to listen.

Ricky Mulvey: Let’s bring this to a few companies. To talk about value drivers, to talk about the expectations for margin, revenue growth, that thing. One you wrote about was Walmart and at the time that I read this outline, it could have changed by the time we’re recording, it trades at about 43 times four or three times trailing 12 months earnings. This is surprising for a company that in a lot of ways functions like a utility, if you look at a company like Kroger next to it, it’s significantly discounted compared to a company like Walmart and you make the case that investors may want to think about how Walmart could double their earnings to justify this stock price. First before we talk about the scenarios in which they could or could not do that, why do investors need to think about how Walmart this behemoth could double its earnings?

Patrick Badolato: Great. I think that starts back to our conversation on the PE ratio. The PE ratio, that’s a pretty healthy valuation. I don’t think anybody’s debating whether or not Walmart’s going to stick around or whether they have some stability, but they’re not being valued right now as just a regular, stable part of the economy. They’ve got a bit of a premium attached to them, so what does that premium mean? I would interpret that premium, the 43 times PE ratio is if you want to make that investment, we have to be expecting earnings growth that’s greater than your average or representative company in the economy, we have to have that expectation.

Our expectation could be wrong, but that’s our reason when we’re going if we think about investing in a company like Walmart, which has already proven itself in many ways, so this is not a start up where we’re trying to figure out if they’ll be profit or whatever else. It has to be based on, hey, they have positive earnings they’ve had for a long time, and I’m certain they will continue but the challenge is will they grow, which I’m not saying I’m certain at at what level but Walmart is not going to be going bankrupt, but will they grow at what rate. That healthy evaluation implies they need at least some meaningful amount of revenue growth and likely also some degree of margin expansion to tie out or rationalize that healthy valuation, so going forward, they’ve clearly performed well in the past, that’s a given, we know that, but going forward, they have to continue to outperform in terms of just a general or representative company in the economy with respect to their earnings growth, driven by future revenue and do our future margin expansion.

Ricky Mulvey: It’s worth asking how they could do that. It would be difficult for a company like Walmart to do that on a grand scale, a company that’s known for its everyday low prices. It doesn’t want to just dramatically raise the prices of its groceries and goods on its customers because that in and of itself is its competitive advantage. That revenue growth becomes difficult and also is a physical retailer margin expansion becomes also very difficult. I think it’s worth thinking about what levers Walmart has to increase its earnings per share when dramatically increasing revenue is difficult and also dramatically increasing margin because it keeps prices low is difficult outside of just decreasing its share count, which can be a very effective tool for a mature company like Walmart.

Patrick Badolato: I actually want to orient back to the, what should we be thinking about in terms of our investment? Let’s just leave out changing the denominator to other factors, any form of financial engineering, not because it doesn’t exist. But let’s focus on their core operations. How could they do this? Ricky, I love the way you set that up for this reason. This is what we need to do with valuation. Just start having conversations. The end we might answer, I don’t know, or I can’t take a position, but start these conversations. Well, if this could happen, then what’s the push-back? Let me try to just give potential scenarios here.

But again, there’s no certainty in any of I don’t think the revenue growth just has to be explosive, but it has to be consistent and steady and decently high. The challenge there is they’re at 650 billion of revenue. That thing has to keep moving up, they cannot rest on their laurels in terms of, we’ve done so well. The second one, margin expansion, I think you laid that out perfectly, and Costco is such a good example of this where similar to Walmart, although slight differences, they’re very clear, they’re not going to raise their prices. I think Doug McMillon has stated a version of that in different forms, the CEO of Walmart. This cannot be from, hey, let’s just increase prices and pass it on. Hope nothing happens. I think that’s just good business sense, what could it be? Well, I think then we have to think about what are the investments?

How is Walmart changing its structure, its operations? One, they are moving towards more automation in their factories, their supply chain. When and how will those cost efficiencies come about? I don’t know but that’s a possible lever. We want to think about how much of their expenses, as long as they keep growing revenue, and as long as the world changes, they make different investments. In the long run here, how can they improve reduce expenses, not by increasing prices necessarily, but by getting more efficiencies in that massive supply chain that they run. Second point here, which I find fascinating is their advertising business. Their advertising business is 3-$4 billion, something around there. It’s really small for that big of a company. But it’s an interesting one because that’s an opportunity for margins that would be very different from the margins they have in their traditional retail.

As that grows or as that changes or as the equilibrium of which companies consumer product companies, who do they pay? They’re not going to be paying cable TV and traditional forms of advertising in the past. Like, does that shape the role of Walmart, specifically when Walmart’s more of a platform with its website. How will that grow? What are the margins of that? I would argue on top of that, what other forms of new aspects of their business can they introduce to gain that margin improvement because I really agree with your point that, could they increase prices? Sure. Would that be long run beneficial for them? Almost surely not. I think it’s more of a new lines of business, specifically things like advertising, and then also opportunities within their supply chain, to really use or to gain more efficiencies.

The last thing I’d offer is retail is changing so much. I think you have two Bhimas. You have Amazon and you have Walmart, and those two companies are showing that they can do things at scale that most others can’t, including, shipping things to our home. As they get better at it, as they get bigger, do they actually not just gain their own general efficiencies, but does that give them an ability to actually push so far as to wipe out some of the competition? Then that’s an incremental form of them to grow in that the consumer demands convenience. We want certain items. We don’t want to pay extra for it and would this be an environment where the biggest have a incrementally beneficial advantage?

Ricky Mulvey: Those are ways it can do it, and if it does it may not need to double its revenue if it can maintain a loftier valuation than that historic average of 20. It would do that based on investors in the future, continuing to think that Walmart’s growth prospects on the things that you just described are continuing further into the future. I think you brought up one of the risks as well when you were discussing the opportunities, and that is within its new lines of business, you could see a company like Walmart going more into something like healthcare, which has tripped up a lot of retailers in the past. As these businesses expand, even as mature businesses, they risk diversification and adding in a bunch of new businesses that take away from the business’ fundamental ability to drive value for their shareholders.

Patrick Badolato: I think that’s a great point in that, an acquisition alone is not a guarantee that you’ll have a value driver. An acquisition makes you bigger. You were talking about Lululemon. An acquisition makes you bigger. It’s not necessarily or a new line of business does make you bigger. That’s not necessarily going to create value. Now, I’m not saying it’ll destroy it, but hey, think about the risk and the opportunities as you just laid out.

Ricky Mulvey: Let’s move on to Nvidia, which more than Walmart right now has a loftier valuation. I think it’s about 65 times earnings. At this rate, if it goes back to that this mantra of the episode of that 20 times earnings baseline, which it may or may not within the next 5-10 years depending on how much it’s able to maintain its competitive advantage on chip design in building these super fast systems on which these large language models run what expectations are you seeing baked into that 65 times earnings valuation or PE price tag for Nvidia?

Patrick Badolato: Great question. I included my conversation on Walmart Nvidia mainly just to show you could take the framework evaluation and apply to anything. These are vastly different. Vastly different companies and, man, the uncertainty with Nvidia is massive. But let’s just mathematically talk about what needs to happen here to tie out this valuation. It’s a lofty, high valuation. Nvidia like Walmart, not the same track record across time, but has performed phenomenally well in the last couple of years, so relatively recent explosive performance, but have crushed.

What do they have here? Well, they still need the massive earnings growth and their potential of doing that I think is very high. Our question is, at what level. Will they keep growing? Are we still in the early innings of the products they’re selling? Yes, but the challenge is how high, at what level and what rate. That’s just a question that involves so much uncertainty. Early equilibrium in the industry. Let me actually directly tie that to their margins. Their margins are amazingly high.

By that, I’m going to talk just their operating margins. Not some embellished version of it, but, revenue minus all their core operating expenses. They’re still absurdly high at this moment in time. The challenge there is that that’s effectively a margin that results from an industry with effectively no competition yet. But those extremely high margins are exactly what’s going to attract new competition, everyone’s going to look at that and say, hey I want a piece of that. I think their compute network margins in the last quarters that segment of the business, the main segment of their business work 71, 72% operating margins.

That’s crazy, but that’s also amazingly attractive to anyone else. What does Nvidia need to do? It needs to have a future that maintains its leadership to tie out its valuation, that maintains its leadership, which translates to it’s still going to have very high, very healthy revenue growth and alongside gain that revenue, be able to achieve that revenue growth without having to do anything like drop prices or change in customers that are going to require them to drop prices so effectively to maintain their margins. I don’t think they necessarily mathematically have to maintain exactly their margins, but they still need very high margins and the long foreseeable future about meaningful growth. But at the same time, tons of uncertainty here. Their industry they’re in, and they’re dominating is still so new. We don’t really know what’s going to come next, how big this will be. This is one that’s amazing conversation. I would argue everyone should think about it and have it, but not one that’s going to give us I love your comment earlier about Excel. There’s no single line or set of formulas we’re going to put in and be like, that’s Nvidia valuation, they should be worth. That’s an unknowable thing right now.

Ricky Mulvey: I use your model on Netflix right now, too, because I think Netflix is a company that is really interesting to talk about value drivers. I know you had a conversation about it back in 2022, where people were, I would say, thinking more about the risks that were happening for Netflix, especially after it had its subscriber drop but I got to this place because I was like, Man, this stock. I was just looking at the price. This is a bad thing to admit to a professor of finance and accounting at the University of Texas McCone School of Business, but I was like, Man, this price has really run up. I’m getting a little itchy on it.

What I did is I put it through the model, and it made me think like, what multiple do I have to expect on Netflix for it to maintain its share price today? What revenue growth would that require and what is the potential miss pricing here? It sounds like a lot, but basically, if Netflix is able to do a cumulative revenue growth in my mind of 100%, which is about 11 I know we’re doing a lot of math. I’m sorry to the listener, 12% over 6 years gets you to about 100% revenue growth, and it needs to maintain a higher than market average multiple. Then you might have a mispricing, and actually Netflix could be undervalued. Now, if competition heats up, if the market assigns a lower multiple and its revenue is not able to increase at that rate, then Netflix stock actually right now would be really overvalued. Right now, I think there’s a lot of questions about Netflix’s value drivers, especially as it pays more for content licensing, as it starts and it starts looking for more subscribers in the ads here and as it starts to look at more emerging markets where it’s not going to be able to charge 20 bucks a month. How are you thinking about value drivers for Netflix right now?

Patrick Badolato: That’s a great question. A couple of things there, and I think you and I have talked before about just the role of the footnotes and the information you can pull out of that. What you’re offering is definitely worth considering. I want to add in one more thing. I think there’s a little bit of margin expansion that they can still get in that they already have that to a certain extent. Over the last couple of years, they’ve improved. Then particularly through the third quarter of 2024, I think they’re sitting at about 20%, sorry, 30%, that matters. That’s a big mistake, 30% operating margin. They have had operating margin improvement. Let me just walk a little bit through. As their revenue grows, there are a company that should get some margin expansion. One, the cost of revenue is basically the main component of that is the amortization of the content assets. But as you have more people subscribing and paying really at any rate, you can actually spread that out. It’s just a classic, I have a cost allocation, I got a fixed cost, I spread out a bigger base, in their case, subscribers, I should get some margin improvement. Now, to be clear, that margin improvement is not going to be some explosive thing. But they do have a chance to consistently grow their earnings or another lever, another lever they can grow their earnings with is with margin improvement over time. Variety of their expenses have a relatively speaking, more of a fixed cost component. As revenue grows, they should get some margin improvement.

But again, I wouldn’t expect that to be explosive. They’ve had that before, so I think another level I want to offer to your conversation. Then I want to push back a little bit on the revenue growth. The challenge to them with revenue growth might be just that they’ve had it. I hate to say this, it’s it’s their success. It’s an amazing company let’s be clear. But they’ve also been really successful at in 2022, we hammered them, the stock dropped to I think I don’t know what it was, but dropped below $200 share. I was buying it at the time, and I’m supposed to disclose that during the drop in 2022. But at that point, we’re like, well, their subscriber growth is going to go down, and they’re really going to struggle here. They changed things, they dropped the sharing of accounts, and I think we all grumbled for a little bit, but then we went back.

That was a great thing for them but the challenge going forward is in there, they have a footnote where they described their subscriber growth across all of theirs the revenue recognition footnote. They describe their subscriber growth across all the different global markets. We’ve seen a lot of that growth already come back. The challenge isn’t, do they have the ability to retain subscribers? I think the answer is definitely yes, but have they baked in or already received the benefits of a lot of the growth to date? Not a knock at all, but at the same time, it’s like, well, would that make the more growth you’ve had in the past and the closer you get to market saturation, doesn’t make it harder to keep growing going forward?

Ricky Mulvey: I will push back on that one time, and then I’m going to have to and then I know we’ll wrap up in a little bit. It does have it may not be able to expand subscribers quite as much, but I think it will continue to have pricing power. Similar to what Spotify did when it introduced audiobooks onto the platform, and then it was able to raise prices and then it’s become this free cash flow engine since then. Netflix may have a similar opportunity as it continues to introduce live events onto the platform, where they’ve started with, the NFL football games, and then they also on Christmas Day, and then they’re also bringing the WWE onto the platform.

The WWE Monday Night Raw was the largest cable show. If you’re a fan of that, maybe they’ll increase prices, and then you can keep your live stuff, and they may have an offering then where, hey, you can bring the price back down, but then you’re going to lose these live events that maybe you really like and enjoy. Last thing on that, where they could expand is it’s in the places we don’t expect. This was a DVD mailing company, and while they haven’t gone to theaters yet for releasing movies, this is becoming more and more of a media company. Now, they’re exploring getting Greta Gerwig’s Narnia movie onto IMAX screens. Maybe they’ll double back on that, similar to the way they have with the advertising platform. I guess I’ll just push back and say, I don’t think it’s just the subscriber count that will drive Netflix’s continued growth, especially in its big market of North America.

Patrick Badolato: I completely agree, Ricky. I’m not going to push back on your push-back. I’m just going to go with you there.

Ricky Mulvey: Push back on the push-back.

Patrick Badolato: Add a little bit but I think that’s a really good perspective, which is that whole thing with the loss of subscribers and then us eventually crawling back, I think I think they knew all along that was going to happen in, what do we have? I think the amount of time the average user spends on Netflix each week is quite high. I would argue, really independent of the live editions, which is a great comment is that the same time, this is probably a price insensitive customer.

Let’s go back to the 80 ‘s and 90 ‘s when we were paying for cable. We’re paying 100 200 bucks a household in the US for no control over the timing, far less content because it was only on at that moment in time and not all these other options. If we were paying that much, and I do understand Netflix is not the only streaming service people subscribe to, but in the long run, and I’m sure they’ll figure out the slow and steady way to do this because, if they double subscription prices, this would fall apart. But I think there’s another lever is I completely agree with you, the opportunity to increase because the consumer is likely price insensitive as long as it’s slow and steady, and then as they change and add offerings to the platform, that should be value to us.

If that’s value to us, they should be able to increase prices. The last thing I’ll say, which is actually consistent with your point is, advertising, to what extent is their ability to actually generate revenue from companies, not from their subscribers, another possible lever. This is a great conversation as a reason. That’s what valuation is. Have these conversations, lay these things out. Try to tie it all back to what could grow their earnings, but I don’t mean earnings in an isolated sense with a PE ratio or that that’s the end of the final part of a conversation. It’s think about what could drive revenue. Think about what their expenses or how they could improve margins. What would be the reasons for that? Try to think about how those conversations work out over time. That’s valuation, begin those conversations. Is there a certain or definite answer? Almost surely not. But hopefully you can flesh it out and engage in conversations and at least, if nothing else, like a starting point to consider should or should I not invested in.

Mary Long: As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and are not approved by advertisers. TMF only picks products that it would personally recommend to friends like you. I’m Mary Long. Thanks for listening. We’ll see you tomorrow.