As of June 6, Nintendo (NASDAQOTH:NTDOY) American depositary receipts had climbed 55% year to date as investor enthusiasm has grown following a very successful launch for its new Switch gaming console. The company sold 2.74 million units of Switch in March, a very strong number after many analysts were skeptical about the system's appeal. A few analysts who were not so skeptical are forecasting Nintendo to sell as many as 40 million units through 2020, which would put Switch on pace to sell as well as competing console hardware like Sony's Playstation 4 and Microsoft's Xbox One.

Excitement for Nintendo's growth prospects is clearly reflected in the stock's forward price-to-earnings ratio of 70, as investors are betting Switch, along with the company's mobile gaming efforts, will rapidly grow earnings in the coming years. Will they be disappointed? Let's analyze Nintendo's valuation, and review the company's key growth drivers to better determine whether Nintendo stock is a good buy now or not.

Nintendo Switch logo in red and white.

Switch is the hit Nintendo needed, but is the stock already factoring this in? IMAGE SOURCE: NINTENDO INC.  

Is Nintendo overvalued?

One way to judge if a stock is overvalued is to compare its valuation to what you can get from other stocks. Facebook, which has grown revenue and earnings about 50% per year over the last five years, has a forward P/E of 31. Alphabet has averaged around 20% annual growth in revenue and earnings for the last 10 years and has a forward P/E of 24. These are well-established companies that have strung together very consistent high growth rates for years, and each offers investors a much lower valuation than Nintendo.

If Switch is a huge success in the next few years and Nintendo delivers growth on par with Facebook or Alphabet, why should we pay a 70 P/E when we can get the same growth from another company for a lower premium? 

What to expect from Nintendo?

Management's financial outlook for fiscal year 2018, ending in March, calls for net sales to reach $7 billion on top of operating profit of $600 million, which is partly based on planned shipments of 10 million Switch units, but keep in mind, these estimates are based on forward-looking currency exchange rates that fluctuate a little every day. The estimates are a major jump over fiscal 2017's $4.5 billion in net sales with $271 million in operating profit.

The bulk of Nintendo's revenue is derived from hardware (Switch and 3DS, for example) and games. The traditional strategy for console manufacturers is to sell the hardware as cheaply as possible (either a small loss or a small profit) and then generate the bulk of profit over time from selling games that earn much higher margins compared to hardware. Nintendo has priced Switch to at least breakeven at $299 per unit, so now we're in wait-and-see mode as to what the installed base of Switch will be in a few years and how many games it sells.

Nintendo is still selling the 3DS handheld, which sold 7.27 million units in fiscal 2017, but that is a very mature product line that doesn't offer the growth Nintendo needs to justify its current valuation.

Management is also beginning to target the mobile gaming market by releasing two or three mobile games per year, like it did last year with Pokemon Go and Super Mario Run. However, Nintendo's mobile efforts are in the very early innings, and it's not clear whether Nintendo will capture enough growth from mobile to meaningfully contribute to the bottom line. Nintendo definitely has potential to be a major player in mobile games, but at this early stage, it would be speculative to buy Nintendo stock with the expectation that mobile games will grow meaningfully for the company.

Is Nintendo a buy?

That leaves us with Switch as the main growth driver for now. The new console has clearly been a hit and will turn Nintendo's business around, but at a forward of P/E 70, investors have better options to find growth for their portfolio.

 

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. John Ballard owns shares of Nintendo. The Motley Fool owns shares of and recommends GOOG, GOOGL, and FB. The Motley Fool has a disclosure policy.