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They Key to Fundamental Growth - Netflix (NASDAQ:NFLX) is Increasing Returns on Capital

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This article was originally published on Simply Wall St News

When a company makes smart investment decisions, it is reflected after a while in its returns. Conversely, strong and growing returns can be a leading indicator to better fundamental performance. Netflix (NASDAQ:NFLX) looks quite promising with regard to its trends of return on capital, which means they are engaged in a business model that creates more value.

The main factors behind the higher returns are the long-term strategy of Netflix, which is currently focused on global growth of their subscriber base, as well as allocating funds for international content development. Netflix tailors content to the characteristics of their audience, and sometimes the successful international content spills over to have a leading global effect - as was the case with Squid Game.

View our latest analysis for Netflix

We can expect to see more original content creation with a different approach than traditional Hollywood. And while the company still makes many mistakes regarding their content, the overall approach may successfully unlock value for international markets.

Looking at the most recent financial results, we see that investors have reason to be optimistic as Netflix keeps delivering, and last week it reported a strong third quarter result with improved earnings, revenues and profit margins.

Third quarter 2021 results:

  • Revenue: US$7.48b (up 16% from 3Q 2020).

  • Net income: US$1.45b (up 83% from 3Q 2020).

  • Profit margin: 19% (up from 12% in 3Q 2020). The increase in margin was driven by higher revenue.

Over the last 3 years, on average, earnings per share has increased by 51% per year, but the company’s share price has only increased by 27% per year, which means it may even be lagging earnings growth. This is offset by this high current value of Netflix, which is trading at 58.3x its earnings.

As Netflix expands, it is important to note that this increases the recognition and prestige of their brand name. This gives them more pricing power and the ability to become a household status symbol, which also drives future growth. One can argue that the social conversations around Netflix's successful shows prompt people to feel left behind if they are not up-to date on the most recent content and developments.

When looking at the quantitative leading indicators to potential higher future growth, we can turn to the different return measures as a way to get a good perspective if the business model is creating more value now, than it was in the past.

One such measure is the Return on Capital Employed, which gives us a measure of the profit made by investing both equity and debt in projects of the company.

Netflix does have some risks though, and we've spotted 2 warning signs for Netflix that you might be interested in.

What is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Netflix, this is the formula:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.19 = US$6.5b ÷ (US$43b - US$8.0b) (Based on the trailing twelve months to September 2021).

Therefore, Netflix has an ROCE of 19%.

On its own, that's a standard return, however it's much better than the 11% generated by the Entertainment industry.

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How Are Returns Trending?

Another important way we can assess the performance is the change of returns overt time. If a company increases its returns, then their projects are now better and can result in more future growth.

The data shows that returns on capital have increased substantially over the last three years, from 9.6% to 19%.

Basically the business is earning more per dollar of capital invested and in addition to that, 336% more capital is being employed now.

On a related note, the company's ratio of current liabilities to total assets has decreased to 19%, which basically reduces it's funding from the likes of short-term creditors or suppliers. So shareholders would be pleased that the growth in returns has mostly come from underlying business performance.

Key Takeaways

In summary, it's great to see that Netflix can compound returns by consistently reinvesting capital at increasing rates of return.

The company now makes 0.19c profit from every $1 dollar it has invested in the business. As we have seen, these returns are mostly coming from better content and more capital invested over time.

The company is focused on the international stage, and the newer content seeks to be tailored to the characteristics and preferences of the audience demographics. People are also equating having a Netflix subscription as being part of the developed world, and being up-to-date on new content can be a prestigious signal in social circles.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

Simply Wall St analyst Goran Damchevski and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com

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