Activision Blizzard Is Better Than You Think

Activision Blizzard (Nasdaq: ATVI) may be better than you think.

In the daily noise machine of CNBC, analyst estimates, and quarterly announcements, investors are inundated with talking heads obsessing over earnings-per-share figures.

Earnings, or net income, is an accounting construction that is the basis for the price-to-earnings ratio, the most popular way of measuring how cheap or expensive a stock is.

But free cash flow -- the amount of cash a company earns on its operations minus what it spends on them -- is another, oftentimes more accurate measure of earnings that can give you an advantage.

How Activision Blizzard stacks up                   
If Activision Blizzard tends to generate more free cash flow than net income, there's a good chance earnings-per-share figures understate its profitability and overstate its price tag. Conversely, if Activision Blizzard consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

This graph compares Activision Blizzard's historical net income to free cash flow. (I omitted various gains and charges such as tax deferrals, restructurings, and benefits related to stock options.)

Source: Capital IQ (a division of Standard & Poor's) and author's calculations.

As you can see, Activision Blizzard has a tendency to produce more free cash flow than net income. This means that the standard price-to-earnings multiple investors use to judge companies may overstate its price tag.

There can be a variety of reasons to disregard such a discrepancy; for example, free cash flow can overstate earnings in businesses with volatile working capital needs, or understate earnings in high growth companies that are reinvesting capital in the business.

Alternatively, in cases where free cash flow more accurately measures earnings, such a discrepancy can indicate a company that is more -- or less -- expensive than investors realize.

Let's examine Activision Blizzard alongside some of its peers for additional context:

* Negative net income. ** Negative free cash flow.

While Activision Blizzard looks moderately priced on a net income basis, it -- like some of its video game peers -- tends to generate more free cash flow than net income, suggesting that the company's stock might quite a bit cheaper than many investors realize.

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