Nintendo (OTC:NTDOY) is one of the most widely-recognized video game companies in the world. The Japanese company, which originally sold playing cards in the late 19th century, has created iconic franchises like Mario, Donkey Kong, and Zelda, and launched revolutionary consoles like the Nintendo Entertainment System, the handheld Game Boy, the motion-sensing Wii, and the hybrid Switch console.

Nintendo has faced many tough competitors over the past three decades, including Sony, Microsoft, and myriad mobile game developers -- but it consistently bounced back from its failures (including the poorly received Wii U) and silenced the critics.

Mario Kart Tour for Android and iOS.

Image source: Nintendo.

That's why, through all the peaks and troughs, Nintendo stock has still outperformed the broad market over the past two decades and more than tripled its return in the past five years. But can Nintendo continue to satisfy the fickle tastes of the crowded video game market? Let's dig deeper to find out.

How does Nintendo make money?

Nintendo generates nearly all its revenue from its gaming hardware, software, and digital subscriptions. In fiscal 2020, which ended in March, it generated 96% of its revenue from its "dedicated video game platform" business, which mainly came from its Switch hardware and software. Sales of its older 3DS console are also included in this segment. Nearly 4% came from its mobile games and IP licensing fees, and the remaining sliver came from its "playing card and other" business, which mainly sells tie-in products for its video game franchises.

Nintendo generated just 23% of its revenue from Japan last year, 43% from the Americas, 25% from Europe, and the remaining 9% from other markets.

How fast is Nintendo growing?

Nintendo's revenue rose 9.0% in 2020, with 8.8% growth in its dedicated video platform revenue and 11.5% growth in mobile and IP revenue.

Its Switch shipments rose 24% to 21.03 million units, as stronger sales of the cheaper Switch Lite, which lacks detachable controllers and a TV mode, offset lower sales of the full-priced model.

Super Mario Maker 2 on the Nintendo Switch.

Image source: Nintendo.

That expanding hardware base lifted its software shipments 42% to 168.7 million units. Top-selling games during the year included Pokemon Sword, Pokemon Shield, Animal Crossing: New Horizons, Luigi's Mansion 3, and Super Mario Maker 2. Its mobile gaming business also continued to lock in players with Animal Crossing: Pocket Camp and Mario Kart Tour.

Nintendo's full-year gross margin expanded from 41.7% to 49.0%, thanks to a higher contribution from software sales (especially higher-margin digital downloads). As a result, its net profit grew 33% for the full year.

Unpredictable headwinds ahead

Nintendo generated impressive growth last year, but it expects tougher headwinds to reduce its revenue and net profit by 8% and 23%, respectively, in fiscal 2021.

Management is guiding for Switch shipments to decline nearly 10% to 19 million and for its software shipments to drop 17% to 140 million units. Nintendo blames those declines on COVID-19, which disrupted its supply chains and retail sales, but the Sony PlayStation 5 and Microsoft Xbox Series X could also present serious challenges during this year's holiday season.

Nintendo also recently hinted it would produce fewer mobile games in the future. That retreat, which might be a response to tough competition and criticisms regarding some of its microtransactions, could lock Nintendo out of the booming market which it has tried to crack over the past four years.

Its upside potential will remain limited

Nintendo's upside potential could be limited for three simple reasons. Its forward price-to-earnings ratio of 21 isn't cheap relative to its near-term growth, its forward yield of 1.1% won't win over serious income investors, and the incoming challenges from the COVID-19 crisis and major new consoles are too serious to ignore.

I wouldn't bet against Nintendo long term though, since it has a consistent track record of producing innovative hardware and owns a rich portfolio of evergreen franchises. However, this stock probably won't go much higher in the coming year unless the company can unexpectedly overcome those above challenges -- investors might want to save their cash for higher-growth gaming stocks.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.