Dueling Fools: Electronic Arts Bull Rebuttal

Wow. Rich actually managed to pan Electronic Arts (NASDAQ:ERTS) without any discussion of the business whatsoever. That's his biggest mistake -- among many others.

Rich asserts that EA's stock is "overvalued," but then he goes on to completely misuse the factors in the calculations he uses to "prove" it.

Of course quality matters
Rich is mistaken when he says that "the quality of a company bears little relevance to whether that company's stock is fairly priced."

Of course it does.

The value of a stock actually comes down to three things --how much cash you expect a company to generate, the timing of the cash flow, and the likelihood that the company will actually make that money. The better the chances that the company will meet your required expectation, the lower the risk, the lower the required margin of safety, and the greater the value of the stock.

So when Rich applies a 12% discount rate to EA's stock where the S&P 500 returns 10.5%, he is suggesting that EA is somehow a riskier and lower-quality business than the average company in the S&P 500. You apply a discount rate to figure out what price you would pay; by Rich's calculation, $47 per share is actually how much he would be willing to pay for the stock, not his estimate of fair value. Having already underestimated that fair value, when Rich says he would pay $40, he is actually double-discounting to make his case fit.

Using a 10.5% discount rate, EA's stock would be worth considerably more than $47. Even then, EA is arguably a superior company to the average S&P 500 stock, and it merits a smaller discount rate -- also known as a premium valuation. That's why Fools are so interested in the stock.

EA is clearly a superior business, particularly compared with its smaller (though highly respectable) rivals, including Activision (NASDAQ:ATVI), Take-Two Interactive (NASDAQ:TTWO), THQ (NASDAQ:THQI), and Midway Games (NYSE:MWY). EA's 63% market share in the sports video game segment speaks volumes, and the company's brand power and scale translate into a sustainable competitive advantage and outsized profits. Note from the table below that EA's net margin for FY 2005 was 16%, where both Activision and Take-Two posted net margins around 10%, and THQ had a net margin just above 8%.

FY 2005 Profit Margin Comparison

Rich uses a PEG ratio based on last year's earnings, but we're clearly in a transition period in this notoriously cyclical industry. Increased R&D expenditures related to next-generation consoles and handhelds from Microsoft (NASDAQ:MSFT), Sony (NYSE:SNE), and Nintendo more than made up the entire $73 million decline in net income from FY 2004 to FY 2005, which means that FY 2005 EPS underestimates EA's earnings power in that period, and thus overstates PEG.

Rich also argues that the analysts' 18.5% forward growth rate over the next five years is "possibly overoptimistic." Based on what assumptions? Rich never even talked about the business.

The bear case here is a lot of legalese and very little substance.

The bull wins. Case closed.

But, wait! You're not done. This is just a quarter of the Duel! Don't miss Rich Smith's bearish beginning, Jeff's bullish argument, and Rich's rebuttal. When you're done, you're still not done. You can vote and let us know who you think won this Duel.

Fool contributor Jeff Hwang owns shares of Electronic Arts. EA and Activision are Motley Fool Stock Advisor picks. The Fool has a disclosure policy.