Roku’s stock price has more than doubled over the last year and FinTwit (the Twitter financial community) continues to be bullish on the company. With its market cap currently around $40B, I thought it would be interesting to look at what needs to be true for the valuation to be justified.
TLDR – To justify today’s stock price, you need to believe the company will go from 45mm active accounts today to 125mm in ten years. In addition, average revenue per user (ARPU) would need to increase from $25 to $95 annually, which would help drive operating margins from -6% today to 21% in ten years.
While this is certainly plausible, there’s also a scenario where ARPU grows much more slowly and is closer to $55 in ten years, which would cause the stock to be worth $210 (all else being equal). Let’s get into the details a little more below, so that you can use your own assumptions to arrive at a valuation for the company. My current best guess puts the company’s value at $258 per share.
Roku’s Business Model
Roku’s founder and CEO, Anthony Wood, knows that selling hardware is a low (to no) margin business, and as a result, has focused the company on selling advertising on its platform. Unlike traditional cable providers, Roku can provide advertisers metrics on just how effective their ads were. The CEO, Anthony Wood, puts it clearly in a Forbes article from a year ago -
“Traditionally, the only way you would measure a TV ad is through Nielsen ratings, which could tell you roughly how many people have watched it,” Wood says. “Our measurement is very precise, where we can tell a company that out of everyone who saw your ad, 5% went to your website and bought something,” he explains. “We’re bringing the sort of technology that’s already been around for a while on the internet to the TV world.
This is a compelling narrative and it’s obvious why investors are excited about this pivot. However, I think its important to ask how willing consumers will be to watch ad supported channels going forward. The majority of U.S. households have either Netflix or Amazon Prime. Not to mention Disney+, Hulu and HBO. Assuming some section of the population is interested in ad supported TV, how big is that market? Will Roku be able to generate ad revenue in line with YouTube today (~$20B), or will it be a fraction of that number, given YouTube has billions of ‘users’.
I’ve had a Roku device for five years and it’s a great box. However, I only watch Netflix, Amazon, HBO and YouTube on it. I’m guessing the vast majority of households are in a similar boat. There’s obviously a market for other channels on Roku that are ad supported, otherwise Roku wouldn’t be earning $1B in revenue from them in 2020. The question is, how big is the market? Will this be $10B in revenue in ten years, or $20B?
Roku doesn’t seem to break down revenue by geography, so I assume the bulk of revenue is currently from the U.S. This means there’s scope for international expansion – mostly in Europe and Latin America. Based on this potential for international expansion and Roku’s willingness to sell the hardware at a loss, as well as the partnerships with TV manufacturers, I forecast 105mm active Roku accounts in 2030. I’m guessing North America will have about 40mm accounts, Europe will have 40mm and LatAm will have about 25mm. Roku’s market share really hasn’t grown in the US since 2015, whereas Amazon has gone from around 10% in 2015 to over 30% in 2019. The space has become very competitive, so I think future growth for Roku is going to be hard won.
Roku’s current ARPU ($25) is in line with Twitter in 2019 ($23). Facebook’s ARPU in 2019 was $31. Given the ad format, I could see ARPU getting to somewhere between Facebook and Netflix (about $140 in the US and EU) in ten years. I therefore assume $85 for ARPU in 2030.
These assumptions for active accounts and ARPU result in $9B in revenue for Roku in ten years. This seems plausible given TV ad spending was $200B in 2019.
Margins
Platform Gross margins improved dramatically in 2020 and are in the high 50% range. By way of context YouTube margins seem to be in the 40% range. Roku can either choose to be niche and have higher platform margins, or they can choose to scale and have margins closer to YouTube. My guess is they’ll stay more niche given the existence of YouTube, so I model platform gross margins of 60%.
I assume operating expenses are about 38% of revenue (in line with Google) to arrive at operating margins for the company of 21% in 2030. This contrasts with -6% in 2019.
Valuation
Based on these assumptions, a terminal FCF multiplier of 25 and a discount rate of 3%, I arrive at a per share value of $258
My sense is these results are ambitious but attainable. The ARPU number is the real wildcard to me. If instead of $85 in 2030, you assume $150, then the stock would be worth over $400.
The recent rally means the market is obviously more bullish on active account growth and ARPU than I am. It seems like anyone can tell a story where a company is earning $2B in ten years and should therefore be worth $50B. I wouldn’t be surprised to see Roku stock go over $400 in the short term given the momentum, but I expect it will correct over the next couple of years as growth disappoints. I could be totally wrong. Time will tell.
As always, my model is available here. I’d love to hear your thoughts on why ARPU or active users will be higher or lower than I’m forecasting.