Quantifying risk and potential reward is a basic requirement for any investment. Companies do it all the time before building a new plant, opening a new store, or investing in research and development. But when it comes to an individual stock, identifying risks and potential rewards is one of the most challenging and abstract concepts.
Some investors will try and use discounted cash flow models to predict future cash flows and then discount them to account for the time value of money. Others will use financial metrics like the price-to-earnings (P/E) ratio to determine if a stock is undervalued or overvalued.
In this article, we're going to take a more conversational approach to risk/reward and think ultra-long term about Walt Disney (DIS 1.54%) stock and why it is a good value now.
Image source: Getty Images.
Why Disney stock is down
Disney stock is down around 45% from its all-time high for a number of reasons. For starters, there are ongoing headwinds from the pandemic. Then there are fears that a recession would decrease discretionary spending, and that would mean fewer people going to the movie theater or the parks. Disney+ continues to lose money. And with Netflix reporting an abysmal quarter, that calls into question the long-term viability of the company's streaming service Disney+. Disney's stance on political issues in Florida has been contentious and has not done the stock any favors. And finally, broader market volatility has pressured Disney stock.
The good news is that the only real long-term headwind affecting Disney is the profitability of Disney+. The other issues are valid, but they are likely only to be short- to medium-term problems.
The business was in peak form before the pandemic
There's every reason to believe that all other aspects of Disney's business will rebound to their 2019 and 2018 levels soon and set new records in the years to come. Let's not forget Disney's success at the box office, which was crushing records in 2019 before the pandemic. In 2019, Disney generated $3.747 billion in inflation-adjusted gross box office revenue, which was 33% of the total box office market share. All told, Disney posted record revenue in fiscal 2019 of $69.61 billion and record profit in fiscal 2018 of $12.60 billion.
It seems likely that Disney+ will eventually be a net positive for the company over the long term, especially considering its growth so far and how it integrates nicely with the parks and movie business. But for now, even with the addition of Disney+, Disney is valued less as a whole than it was pre-pandemic.
Unlike Disney's films, which are still in the process of rebounding, Disney's parks are already showing that they are close to their pre-pandemic form. Domestic parks generated 40% higher per capita spending in Q1 fiscal 2022 compared to Q1 fiscal 2019 -- which helped Disney earn 95% as much revenue in the 2021 calendar year holiday quarter as it did in the calendar year 2019 holiday quarter.
Even with heightened Disney+ investment, Disney continues to invest in its parks with the Star Wars: Galactic Starcruiser, which opened in March, and the Guardians of the Galaxy: Cosmic Rewind, a highly anticipated ride that opens at EPCOT on May 27.
The parks, media, and studio entertainment businesses are the lifeblood of Disney. Disney typically fetches 20%-plus operating margins from its parks, which can be used to reinvest in the parks or other long-term plays like Disney+.
An attractive valuation
Disney stock's lowest point in the last seven years was when it hit $79.07 per share intraday on March 18, 2020. This was the point in time when the S&P 500 was down over 30%, fear related to COVID-19 was surging, uncertainty was high, and no one knew how bad the pandemic was or how long it was going to last. Disney+ was less than six months into its launch and had yet to prove itself.
All stocks can go to $0. But that $79 per share mark provides a reasonable floor for Disney stock. It is about 30% lower than the current stock price. However, the all-time high for Disney was $203.02 per share on March 8, 2021. That high was achieved when optimism toward Disney+ was strong, and there was decent confidence that the parks and movie businesses were rebounding. It seems more likely to me that optimism toward Disney will return to 2019 levels sometime in the next five years than pessimism reaches the max fear index during the pandemic. For that reason alone, the risk/reward profile of Disney is incredibly attractive.
Let's take it a step further. If you think that the company will eventually surpass its record parks and movie profits and Disney+ will one day reach profitability, then the stock could go much higher than its prior all-time high -- which is a far greater reward than the risk that it will go back down to the peak panic level of $79 per share or so. So, the upside is well over 100%, but I believe that the downside is only about 30%. That suggests Disney has a compelling risk/reward profile, but only because record profits are yet to come and the company's best days are ahead of it, not behind it.
To back up the valuation argument even more, consider that Disney's record net income was $12.6 billion in 2018. If it were to achieve that level of net income now, it would have a P/E ratio of 16.4. However, that's unrealistic because Disney is spending a lot of money on Disney+, which again isn't profitable yet. Even so, analyst consensus estimates are that Disney will earn $5.40 in earnings per share in 2023, which would give it a 2023 forward P/E ratio of around 21 -- which is inexpensive considering Disney still wouldn't even be close to its potential profit margin for Disney+.
A final thought
Buying during a bear market is never easy. It's hard to have the confidence to buy when stocks just seem to set new lows every week. However, for a company like Disney, which is one of the most powerful brands in the world and has tons of growth potential, the risk/reward profile is incredibly attractive.
