Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Stocks (as a whole) have rarely been as expensive as they are today. The data confirms it.
Currently, stocks on the S&P 500 average a valuation of 25 times trailing earnings. A dispassionate look at the data shows that since the index was established in 1923, there have been only three other periods in which stocks on the S&P 500 equaled or exceeded this value.
That news in and of itself may make you nervous, but here's something else you should know: Within the S&P 500, there are sectors that cost even more. Gaming software, for instance.
Hurray! We have a high score!
Financial data aggregator finviz.com confirms that each of the three highest-profile video gaming companies in the U.S. -- Electronic Arts (NASDAQ:EA), Activision Blizzard (NASDAQ:ATVI), and Take-Two Interactive (NASDAQ:TTWO) -- score P/E ratios of roughly 32 times earnings, 44 times earnings, and 68 times earnings, respectively. And yet, despite these high prices, Electronic Arts, Activision, and Take-Two are the three stocks that NYC-based equity researcher Buckingham Research decided to initiate coverage on today -- all with buy ratings.
Reasons for optimism
Why are gaming stocks so much more expensive than the already expensive stocks found elsewhere on the S&P 500? Well, investors (and analysts) expect a lot more growth out of these companies than they expect the average S&P 500 stock to produce.
Morningstar data, for example, suggest that on average, analysts expect earnings on the S&P 500 to grow at about 9.8% annually over the next five years. Gaming stocks, on the other hand, are expected to grow much, much faster.
On finviz, the cheapest of the big video gamers, Electronic Arts, is pegged for a long-term growth rate in excess of 15% -- 50% faster than the average S&P 500 stock. Activision and Take-Two meanwhile, are expected to grow their earnings at the even faster rates of 21% and 20%, respectively -- roughly twice as fast as the average S&P 500 stock.
Hence, the higher prices investors are willing to pay for them.
Is the optimism justified?
So what lies behind all this optimism about growth in gaming, and is it justified? Our friends at TheFly.com were kind enough to share details on Buckingham's three upgrades today. As they report, the main thesis behind Buckingham's three-pronged endorsement of EA, Activision, and Take-Two is the analyst's belief that a "shift to digital distribution and in-game content delivery" is underway in the gaming world.
These trends will be "game changers for the video game publishers," says Buckingham. Releasing publishers from their reliance on third-party distributors to sell their wares, Buckingham believes, will yield both "better revenue predictability and higher margins" for publishers like EA. As these trends bear fruit, Buckingham predicts we will see management at all three companies continue to raise guidance for sales and earnings, leading to "multiple expansion," and even higher P/E ratios for EA and its peers.
Among these peers by the way, Buckingham says that Activision Blizzard "is the best managed and best positioned company within the video game sector to benefit from" these trends. Accordingly, Buckingham is assigning a $79 price target to Activision stock, which implies 23% upside for new investors.
Electronic Arts gets a $143 price target -- 19% upside.
And Take-Two takes third place in Buckingham's review of the gaming industry. Its $120 price target implies Take-Two shares will rise 17% over the next 12 months.
The most important thing: Valuing the video gamers
So...does all this mean you should rush right out and buy shares of Electronic Arts stock, and Activision Blizzard and Take-Two Interactive as well?
Maybe, but also maybe not. From a pure PEG perspective, I have to say that buying Electronic Arts at 32 times earnings, with a 15% projected growth rate, doesn't look like a particularly attractive value proposition. Likewise Activision stock at 44 times earnings and 21% growth, and (especially) Take-Two at 68 times earnings and only 20% growth.
On the other hand though, it's worth pointing out that all three of these companies generate significantly greater free cash flow from their businesses than their income statements reflect. Electronic Arts' $1.6 billion in free cash flow generated over the past year dwarf the company's $1.2 billion in reported net income, for example. Likewise Activision's $1.9 billion in free cash flow (versus $1.1 billion in earnings). Take-Two is almost literally twice as profitable on a cash basis (free cash flow of $301 million) as it appears under GAAP (reported earnings of $166 million).
None of the three stocks meets my criteria for becoming a deep value investment just yet. But they're getting close.
Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Activision Blizzard and Take-Two Interactive Software. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.