Lucky Jeff. I can picture him right now, chuckling into his morning coffee at the thought of my trying to knock the shine off of Electronic Arts (NASDAQ:ERTS). After all, EA is the undisputed king of video gaming, and its stock has returned better-than-90% profits to members of Motley Fool Stock Advisor who bought it on David Gardner's recommendation back in May of 2002.
Well, stop chortling, Jeff. I'm not going to knock EA, the company. It's a fine software shop and I've got nothing against it.
But as for EA's amazing rise in value since receiving David's endorsement, well, that's the basis for my dislike of EA, the stock.
Valuation matters
Let's begin with the obvious. EA's PEG ratio (its P/E divided by its growth rate) is positively obscene -- the stock sells for 43 times earnings. Are you kidding me? A first-grade value investor could tell you that a company cannot be fairly priced when it sells for much over a PEG of 1.0. Yet if you divide EA's P/E of 43 by the growth rate that analysts predict for the company -- 18.5% annualized over the next five years -- you arrive at a PEG of 2.3.
That's more than twice what any value investor would pay for a company.
A Bimmer of a software company
Sure, I know what you're going to say: EA is not just any software company. It's king of the video game hill. Top of the heap. The smile on the Mona Lisa. Whatever.
Listen, Fools. Every company has a fair price. The bad companies. The good companies. The great companies. Company stocks are just like cars in that respect. You wouldn't pay $25,000 for a Hyundai Elantra, would you? Likewise, you probably wouldn't shell out $50,000 for a BMW 3-series.
Similarly, the quality of a company bears little relevance to whether that company's stock is fairly priced. To calculate a fair price, you need to know how much cash the company can generate for its shareholders over the company's lifetime, then figure out how much that cash is worth in today's dollars. If the price you're asked to pay today can earn you adequate profits over time, then it's a fair one. If not, it isn't.
To determine whether EA is fairly priced, I ran EA's numbers through the Fool's own discounted cash flow calculator (freely available to all members of Motley Fool Inside Value). Assuming we want to earn a bit more than the usual 10.5% returns available from investing in an S&P index fund, I plugged in a discount rate of 12% for EA's stock. Then I gave the company literally every benefit of the doubt in calculating how much money it might earn for its investors over its lifetime. I used analysts' (possibly overoptimistic) 18.5% forward growth estimates for the first five years, and assumed the company can at least keep pace with the S&P over the next five. What's more, I valued the company based on its free cash flow, which is richer than its reported earnings under GAAP.
A $50,000 Bimmer
The result: EA is a $50,000 BMW of a stock -- great quality, lousy price. According to the calculator's analysis of EA's likely cash flows, discounted to their present-day value, EA shares are worth just $47 -- more than $10 less than today's price. Not to put too fine a point on it, EA's stock is kryptonite for the value investor. Far from offering any margin of safety, the stock currently sells for more than 22% over its fair value.
Back to the company
Let me close by emphasizing: I love EA, the company. If the stock were selling for $40, I'd buy. But at its current price, I'd suggest you hold off plunking down your hard-earned cash on EA stock. Buying at this price is the surest way to ensure that your portfolio gets fragged.
But, wait! You're not done. This is just a quarter of the Duel! Don't miss Jeff Hwang's bullish argument, Rich's rebuttal, or Jeff's final word. When you're done, you're still not done. You can vote and let us know who you think won this Duel.
Fool contributor Rich Smith does not own, nor is he short, shares of Electronic Arts. If he did (or was), The Motley Fool would require him to tell you so. We're sticklers about things like that.
