Has Perfect World Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Perfect World (Nasdaq: PWRD  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Perfect World.

Factor

What We Want to See

Actual

Pass or Fail?

Growth

5-Year Annual Revenue Growth > 15%

35%

Pass

 

1-Year Revenue Growth > 12%

2.5%

Fail

Margins

Gross Margin > 35%

81.9%

Pass

 

Net Margin > 15%

24.9%

Pass

Balance Sheet

Debt to Equity < 50%

19.2%

Pass

 

Current Ratio > 1.3

1.96

Pass

Opportunities

Return on Equity > 15%

18.9%

Pass

Valuation

Normalized P/E < 20

6.18

Pass

Dividends

Current Yield > 2%

0%

Fail

 

5-Year Dividend Growth > 10%

0%

Fail

       
 

Total Score

 

7 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Perfect World last year, the company has dropped a point. The stock has also been a bit of a disappointment for investors, with gains of only 5% or so over the past year.

China has proven to be a mecca of online gamers, with Perfect World and many competitors catering to give gamers the entertainment they want. In particular, Perfect World offers massively multiplayer online role-playing games, and it grew from a tiny player to a huge company in the span of just five years. 

But the weaker growth that China's economy has produced more recently has shown up in revenue drops throughout the industry. In August, Perfect World posted a 13% drop in sales, following Shanda Games (Nasdaq: GAME  ) and NetEase (Nasdaq: NTES  ) in falling short of analysts' revenue estimates. With expectations for Perfect World and Shanda to keep seeing sales drop in 2013, NetEase and Giant Interactive (NYSE: GA  ) could easily end up taking market share from their laggard competitors.

Earlier in the year, Perfect World also suffered from rumors of fraud. The number of discoveries of fraudulent Chinese small-cap company has cast a pall over even legitimate businesses, and the unfortunate confluence of weaker numbers only makes rumor-mongers seem more believable in some quarters.

For Perfect World to improve, it needs to get revenue growth back to levels it once enjoyed. That may require consolidation in the crowded industry, as Activision Blizzard (Nasdaq: ATVI  ) and other companies that have substantial U.S. console-game sales seek to diversify geographically. With only modest debt and cheap valuations throughout the space, Perfect World might do best to take matters into its own hands and make a bid to gain size by grabbing up a rival.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

China's online industry has spawned plenty of in-country businesses, but in many cases, profiting from our increasingly global economy can be as easy as investing in your own backyard. Our free report 3 American Companies Set to Dominate the World shows you how. Click here to get your free copy before it's gone.

Click here to add Perfect World to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.


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