There tends to be a lot of bad information about the gaming industry for investors to sift through online these days. I see a combination of traders trumpeting a stock during a short-term rally, analysts expressing surprise when a company beats or misses their numbers, and a general misunderstanding of the industry.
So let's take a step back and take a look at what's really important when analyzing gaming stocks.
The typical numbers don't matter
It's often too easy to analyze a stock based on a few common numbers. P/E ratios, book values, and net income growth is often the first, and sometimes the last, thing we look at. In gaming, these numbers don't matter a bit when you're trying to value a company.
The heart of the misunderstanding is the way the gaming business is built. A company like Las Vegas Sands (NYSE: LVS), Wynn Resorts (Nasdaq: WYNN), or Melco Crown (Nasdaq: MPEL) will build a massive, expensive casino, which essentially becomes a money tree. How fast the money falls determines how much the tree is worth. Extraneous numbers don't matter.
After a casino is built, I don't care what it cost to construct, because I want to know what it's worth, not what the accounting books say it's worth. These accounting rules are the first thing that gets in the way of investor understanding.
Let's first debunk net income. When a company calculates net income, it takes revenue, subtracts cash costs such as labor and materials, subtracts non-cash costs such as depreciation, and then subtracts financing costs and taxes to get net income. Since I only care about the cash the casino is spitting off, I don't care about depreciation. It could be $1 million or $1 billion; it makes little difference to me, except for tax purposes. Financing costs don't matter to me either, but I'll explain that in a minute. This is why we use EBITDA, or earnings before interest, taxes, depreciation, and amortization, as a proxy for how much money a casino is throwing off.
Since we care more about EBITDA than net income, it's easy to see why net income growth doesn't mean much. If I have $1 million in EBITDA and $1,000 of net income this year and $1.001 million of EBITDA and $2,000 of net income next year, my growth looks great but I haven't really improved the business very much. The same goes for casinos. When you're ramping up new casinos, as companies have done in recent years, your net income will not really reflect how fast your business is growing.
So let's stop using P/E ratios and book values to talk about gaming stocks. They simply don't mean very much in this business.
Some numbers do matter
I've explained why EBITDA matters for analyzing gaming companies; the second most important number is enterprise value, which, in this case, is the value of securities all owners in a casino hold. Since debtholders are essentially owners, we have to include them in the calculation as well. I took out interest costs above, and that's the portion of EBITDA paid to these owners. Equity owners get everything that's left over.
So when I value casino companies, as I do every quarter, I add the market value of the stock to the book value of the debt, and I subtract cash, on the assumption that this could be used to pay off debt. This calculation results in the value of the entire company, or enterprise value.
When you compare enterprise value to EBITDA you get a ratio -- not dissimilar to the P/E ratio, but more relevant in the case of casino companies. This ratio is at the heart of valuing these companies.
The judgment calls begin
From here, there can be a lot of interpretations of what company is the best value. Caesars Entertainment's (Nasdaq: CZR) enterprise trades at 10.4 times EBITDA right now, but should that be higher or lower? The company is in slow growth markets, so I would argue that a ratio of 6 to 8 would be more accurate. But Caesars' debt alone is 9.7 times EBITDA, so now what?
Melco Crown, Wynn Resorts, and Las Vegas Sands all traded with EB/EBITDA multiples of 10 to 11 in my analysis linked above, after projecting Sands Cotai Central. Whether this number should be higher or lower depends on how fast you think Macau will grow. But does it make sense that MGM Resorts (NYSE: MGM) trades at the same multiple with so little exposure to Macau?
You may even find value in companies you haven't heard of. Monarch Casino & Resort's enterprise trades at 6.2 times EBITDA, with a vast majority of the enterprise consisting of equity. Not bad for a casino company.
Foolish bottom line
Analyzing gaming stocks isn't hard; you just have to look at the right numbers. EBITDA and enterprise value should be the two main things we talk about, not P/E ratios or book values. Those numbers simply hold little meaning in the context of a gaming stock.
For more about gaming stocks, add them to My Watchlist, and My Watchlist will find all of our Foolish analysis on each stock.
- Add Wynn Resorts to My Watchlist.
- Add Melco Crown Entertainment to My Watchlist.
- Add MGM Resorts International to My Watchlist.
- Add Monarch Casino & Resort to My Watchlist.
- Add Las Vegas Sands to My Watchlist.
- Add Caesars Entertainment to My Watchlist.
