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The renewal rates often differ for existing vs. new subscribers because new customers tend to cancel more quickly; once someone has been around for a few years, he/she is more likely to stay subscribed.

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.

Breaking Into Wall Street is the only financial modeling training platform that uses real-life modeling tests and interview case studies to give you an unfair advantage in investment banking and private equity interviews - and a leg up once you win your offer and start working.

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As an investor many a times, the biggest issue is are you investing in productive assets? Seeking long term growth potential? How do you seek out those companies? Revenue per employee targets? Looking to the balance sheet to find the change in book value per share as a measure of ability to add value for shareholders, comparison of book value growth to the returns?income statement measures and the list goes on. Recently I was engaged with some of my mentees on the idea of Netflix the possible transformation that grew its market capitalization climbing to $139 billion in March 2018.

Netflix (NASDAQ:NFLX) has changed not just the entertainment business, but also the way that we (the audience) watch television. In the process, it has also enriched its investors, as its market capitalization climbed to $139 billion in March 2018 and even after the market correction for the FANG stocks, its value is substantial enough to make it one of the largest entertainment company in the world. Among the FANG stocks, with their gigantic market capitalizations, it remains the smallest company on both market value and operating metrics, but it has almost as big an impact on our daily lives as its larger peers.

Allow me to over analyze for a split second Netflix's operating metrics, as it captures the essence of the Netflix success story. While Netflix has been able to grow revenues in each of the three consecutive five-year time periods, 2002-2006, 2007-2012 and 2013-2017, that it has been existence, the company has been faced with challenges during each period, and it has adapted.

DVDs in the Mail: In the first five-year period, 2002 through to 2006, the company mailed out DVD and videos to ts subscribers, challenging the video rental business, where brick and mortar video rental stores represented the status quo, the Blockbuster was the dominant player.

The Rise of Streaming: It was between 2007 and 2012 , where Netflix came into its own, as it took advantage of changes in technology and in customer preferences. First, as technology evolved to allow for the streaming of movies, Netflix adapted, with a few rough patches, to the new technology, while its brick and mortar competitors imploded. Second, while Netflix saw a drop in revenue growth that was not unexpected, given its larger base, it also saw its content costs rise at a faster rate than revenues, as content providers (the movie studios) starting charging higher prices for content.

The Content Maker: In hindsight, the studios probably wish that they had not squeezed Netflix, because the company reacted by taking more control of its own destiny in the 2013- 2017 time period, by shifting to original content, first with television series and later with direct-to-streaming movies. The results have upended the entertainment business, but more critically for Netflix, they show up in a more critical statistic. For the first time in its existence, Netflix saw content costs rise at a rate slower than its growth in revenues, with operating profit margins, both before and after R&D reflecting this development.

There is already widespread speculation that even though Netflix's stock has performed well, any individual stock can over- or under-perform and past returns do not predict future results. Plus, competitors like Disney, with plans to launch their own streaming services, could likely pull content, and potentially viewers, from Netflix.

It is my belief that Netflix will scale to a large and highly profitable business, and 1Q results highlight continued momentum on both scale and margins. In a rare combination, subscriber growth exceeded expectations AND expectations for margin expansion for the year increased. Importantly, as the company pivots its incremental spending from content first toward marketing, there are some early signs that operating leverage is increasing and cash burn perhaps peaking.

Last year, Netflix announced it would spend $7-$8 billion on content in 2018, including for its own original content. The company inked an exclusive deal and completed an acquisition with comic-book company Millarworld.

The general caution is that, if you're considering investing in Netflix or in the stock market in general, experts advise starting slow. Experienced investors Warren Buffett, Mark Cuban and Tony Robbins suggest beginning with index funds, which hold every stock in an index, offer low turnover rates, attendant fees and tax bills, and fluctuate with the market to eliminate the risk of picking individual stocks.

1. It's a big spender on content: In 2017, Netflix spent billions on the content that it delivers to its subscribers, and the extent of its spending can be seen in its financial statements. The way that Netflix accounts for its content expenditures does complicate the measurement, since it uses two different accounting standards, one for licensed content and one for productions, but it capitalizes and amortizes both, albeit on different schedules, and based upon viewing patterns.

2. An increasing amount of that spending goes to original content: The decision by Netflix to produce some of its own content in 2013 triggered a shift towards original content that has picked up speed since that year. In 2017, the company spent $6.3 billion on original content, putting it among the top spenders in the entertainment business:

3. Netflix has been adept at playing the expectations game: One feature that all of the FANG stocks trade is that rather than let equity research analysts frame their stories and measure their success, they have managed to frame their own stories and make investors and analysts play on their terms. Netflix, for instance, has managed to make the expectations game all about subscriber numbers, and every earnings report of the company is framed around these numbers, with less attention paid to content costs, churn rates and negative cash flows. After its most recent earnings report in January, the stock price surged, as the company reported an increase of 8.3 million in subscribers, well above expectations.

4. The company is globalizing: One consequence of making it a numbers game, which is what Netflix has done by keeping the focus on subscribers, is that you have to go where the numbers are, and for better or worse, that has meant that Netflix has had to go global, with Asia being the mother lode.

At the end of 2017, Netflix had more subscribers outside the US than in the US, and it is bringing its free spending ways and its views on content development to other parts of the world, perhaps bringing Bollywood and Hollywood closer, at least in terms of shared problems.

In summary, Netflix has built a business model of spending immense amounts on content, using that content to attract new subscribers, and then using those new subscribers as its pathway to market value. It is clear that investors have bought into the model, but the model is also one that burns through cash at alarming rates, with no smooth or near term escape hatch.

The key to getting a subscriber-based valuation of Netflix is to first break its overall costs down into (a) costs for servicing existing subscribers, (b) the cost of acquiring new subscribers and (c) a corporate cost that cannot be directly related to either servicing existing subscribers or getting new ones. I started with the Netflix 2017 income statement:

Since Netflix does not break its costs down into preferred components I made subjective judgments in allocating these costs, treating G&A costs as expenses related to servicing existing subscribers and marketing costs as the costs of acquiring new subscribers. With content costs, I started first with the $2,146 million difference between the cash content cost and expensed content cost and treated it also as part of the cost of acquiring new subscribers. With the expensed content cost of $7,600 million, I assumed that only 20% of these costs are directly related to subscribers and treated that portion as part of the cost of servicing existing subscribers and that the remaining 80% would become part of the corporate cost, in conjunction with the investment in technology and development. One key difference between the Netflix and Spotify cost models is that most of the content costs are fixed corporate costs for Netflix but almost all content costsare variable costs for Spotify, since it pays for content based upon how its subscribers listen to it, rather than as a fixed fee.

My decision to treat most of the content content costs as a corporate cost has predictable consequences. The costs associated with individual subscribers are only the G&A costs and 20% of content costs, and the number is small, relative to the revenues that Netflix generates per subscriber:

To value a new subscriber, I first estimated the total cost that Netflix spent on adding new subscribers by adding the total marketing costs of $1,278 million to the capitalized portion of the content costs of $2,142 million, and then divided this amount by the gross increase in the number of subscribers (30.84 million) during 2017, to obtain a cost of $111.01 for acquiring a new subscriber. I then net that number out from the value of an existing subscriber to arrive at a value of $397.88/new subscriber right now; I assume that this value will increase at the inflation rate over time.

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