Disney (NYSE:DIS) stock is one of the most profitable positions in my portfolio, accumulating a gain of more than 200% over the last five years. When something like this happens it's important to go beyond congratulating yourself and resting on your laurels. The main question at this point is: Should I take gains at these levels or is it better to hold on to Disney stock for the long term?
The magic factory is firing on all cylinders
Disney is an undisputed leader in the global entertainment industry. Brand differentiation is a crucial competitive advantage in this sector, and Disney comes second to none thanks to the power and ubiquity of names such as ABC, ESPN, Pixar, and Disney itself.
The company owns the rights to profit from many of the most popular franchises and fictional characters around, from Mickey Mouse to Darth Vader. Also, top human talent and enormous firepower to invest in production and marketing put the company a few steps above the competition when it comes to creating and promoting successful content.
Disney gets to make money from its assets via multiple platforms, and this means the business model is particularly profitable. Frozen was a mind-blowing success for the company, winning an Oscar and becoming the highest-grossing animated movie of all time. More than a year after its release, Frozen was both the biggest and fastest growing property in the toy industry during 2014, and Disney is still profiting from its popularity via other venues such as home entertainment and amusement park attractions.
The magic factory is firing on all cylinders from a financial point of view, as Disney delivered both record revenue and earnings during the quarter ended in December. Sales grew 9% year over year to $13.4 billion, while earnings per share jumped 23% on the back of expanding profit margins. Operating cash flow increased 53% during the quarter, and free cash flow grew 55% versus the same period in the prior year.
And the best may be yet to come. Tomorrowland, an original Disney adventure starring George Clooney, will be released in spring, and the Avengers sequel, Avengers: Age of Ultron opens in May. Also, the company has two Pixar movies on the way this year: Inside Out and The Good Dinosaur. In case this is not exciting enough, the massively anticipated Star Wars: The Force Awakens, is scheduled for release in December.
In the spring of next year, Disney is planning to open its new Shanghai Disney Resort. The resort, which broke ground in 2011, will occupy an area of 963 acres and will be one of Disney's biggest projects ever. Considering the size and magnitude of the project, as well as Disney's competitive strengths, this could open the door to many exciting possibilities for international expansion in the years ahead.
The main risk when it comes to Disney
The last time that Disney delivered an earnings report below expectations was in May 2011. This speaks wonders about the company from a long-term point of view. Winners tend to keep on winning, and Disney is definitively a world class winner.
On the other hand, demanding expectations are always a source of risk, and investors are clearly expecting a lot from the company. After so many consecutive quarters of beating expectations, the bar is getting higher. Wall Street analysts have been consistently raising their sales and earnings forecasts for Disney in reaction to better than expected performance, and sooner or later they will err on the side of too much optimism.
Disney trades at a P/E ratio around 23.5, a premium versus the S&P 500 index, which carries a P/E ratio in the neighborhood of 19.5 times earnings. The company can clearly justify an above-average valuation, but the stock is still vulnerable to any disappointment in the middle term.
I'm still willing to assume valuation risk when it comes to Disney, though. Disney is a superior company trading at an above-average valuation, if there is a sell-off because expectations get too overheated, it will most likely turn out to be a buying opportunity in an exceptional business at a convenient entry price.
Disney is a top quality company to hold over the years, adding to the position on short-term pullbacks down the road. Aggressive expectations can be a source of risk in the short term, but the long term growth story is still remarkably exciting. For this reason I'm planning to stick with Disney stock to infinity and beyond.
Andrés Cardenal owns shares of Walt Disney. The Motley Fool recommends Walt Disney. The Motley Fool owns shares of Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.