Readers of the Cornell Capital Group blog will note that Roku made our list of bubble 2.0 stocks. So far, it is still bubbling along. It is up over 300% since the beginning of the year and up 13% since we posted it on our list of bubble stocks. As the Wall Street Journal puts it, “Roku finds itself in a prime position at a time when companies are increasingly looking to advertise on platforms like Roku instead of cable TV.” So, what does Roku have to do to justify a valuation that is nearly 20 times revenue and 154 times gross profit? The only way to answer that question is to dive in and develop a discounted cash flow valuation model. Our model, which can be downloaded below, is shown in the exhibit.
There are several strongly optimistic assumptions incorporated in the model.
1) The growth in revenue for the first five years exceeds the historical growth.
2) The gross profit margin remains high, stabilizing at 40 percent pf revenue.
3) Operating costs fall from 50 percent of revenue to 11 percent of revenue.
4) The discount rate of 12.5 percent is in line with the predictions of the CAPM.
As a result of these assumptions, net operating profit after tax, NOPAT, and free cash flow both grow dramatically as shown in the exhibit.
The reason we see these assumptions as being so optimistic is that they downplay the role of competition. In our view, the key question that investors should be asking is, what are the barriers to entry? What is it that will prevent competitors from entering and undoing Roku’s efforts to become a predominant portal in the television streaming space? In our estimation, there are none. Certainly, not the hardware – devices that receive the streaming signal are easy to produce. Ditto for the front-end software. In fact, what surprises us is the extent to which competitors like Apple and Amazon have let Roku establish the position it has without a more aggressive competitive response. But the competition is picking up. Last week Amazon held a sale on fire sticks at Best Buy with prices cut to $14.95 and $18.95 for the HD and 4k versions. The salesman at one Best Buy told us the goal was to compete with Roku. Every store sold out. Sony and LG are now shipping their high-end TVs with Google Assistant built in while Samsung has added Alexa. In the face of this growing competition, we feel that the assumptions in the exhibit are highly optimistic.
The surprising fact is that as optimistic as the assumptions in the exhibit are, they result in an implied stock price of only $74.93 compared to a market price of $135. Furthermore, the calculations in the exhibit do not include the possibility of bankruptcy. Given the rapid evolution in the media space, this is probably an oversight. If we were to include say a 10% probability of bankruptcy, then all the revenue and earnings numbers would have to be adjusted upward by about 10% to justify the estimated value of $74.93. This stretches credulity even further.
To conclude, our valuation analysis is consistent with Roku being on the bubble list. Despite making highly rosy assumption, we still arrived at an estimated stock price that was more than 40 percent below the market price. However, this does not mean you should short the stock or sell call options. As Arnott, Cornell and Shepard stress, bubbles can continue to inflate long after the price of a stock exceeds a rational level. But it does mean that at a price of $135 Roku is a stock to avoid. The DCF model implies that at that level, the downside risk far outweighs the upside potential.