Jeff-
You make some good points, but I must disagree with you on your valuation discussion. THQI is "unfairly valued." Frankly, with a P/E of 12-20, THQI is still undervalued. And, by the way, THQI's present P/E is closer to 10. I agree that ERTS is overpriced at 40x. But the question about paying 40x for any game company is irrelevant, in my opinion. With few exceptions, it shouldn't matter what the company makes, as long as the industry is growing and the company gains market share. The interactive entertainment industry is the fastest-growing segment of the entertainment industry, and among the fastest in the entire consumer products sector. That's a substantial record. And the long-term outlook for the industry is equally excellent. ERTS is the undisputed leader, and deserves a premium for the confidence that it will survive and thrive. However, it's not likely to outpace industry growth in the future, so I believe it should command a multiple of perhaps 30x. But that's in a sane stock market. And James Lin at Wedbush said that ERTS trading at its current price "is a joke." Perhaps he believes it deserves a P/E of 60? That's insane.
And during the past couple of years, THQI should have had a multiple above 40, in my opinion. It still should have a valuation at least 3 times the current one. It has the best operating margins in the business and it trades at ONE TIMES SALES!!!
But P/Es are more than arbitrarily-chosen figures. They should indicate the length of time over which someone should expect a 100% return on investment through cash flow. For example, real estate people I know say that they expect a 100% return on their investment in 8-10 years. Obviously, most folks don't see stocks as long-term investments like real estate, perhaps because of the increased liquidity of stocks, but the financial principle is the same. A valuation multiple of cash flow should consider growth rate and time frame.
Using THQI as an example, let's look at the past investment opportunity represented by the stock. When I first bought the stock in 1996, it traded for $2.50 or so. If it were a private company that I purchased for that price, I would have done fabulously well. 2.5 years after my investment (which would have been 6 months ago), I would have recouped $2.50 in cash flow generated from operations. Assume that two years ago, when THQI fell to $4 after the secondary, I bought the whole company. Since then, THQI has made about $2.90 in cash flow. According to analysts' estimates THQI will make over a dollar in the next 6 months. Again, 2.5 years will have been needed to recover the investment through cash flow. From early last year, when THQI traded around $12 ($10 after cash), to now, it took only one year to recover $2 in cash. If THQI makes $3.40 this year and over $4.50 in 2000, it will have produced $10 in cash in 3 years. And today at $20 ($16 or so after cash), it will take (using my estimates for 1999 and 2000 and 30% long-term growth thereafter) only 3 years and a quarter to recover the initial investment. (Of course, I haven't discounted future cash flows by any long-term interest rate-- but that wouldn't make a substantial difference).
If you ask any real estate investor (or any venture capital investor), they'll tell you that this is a tremendous investment return. This is especially true when you consider the value of the company's stock, which is worth much more than the operating cash flow. If you have an 8 year time horizon for THQI and believe it can grow by 25% for the siz years after 2000 (certainly feasible given the growth of ERTS at $1.4 billion in sales), you can assign a P/E of 35 to it. I calculated this by summing the cash generated by operations in the next 8 years: $3.40, $4.60, $5.75, $7.19, $8.98, $11.23, $14.03, $17.55. The total is $72.73. That's a P/E of approximately 35. If you use a 10% discount rate, perhaps the P/E should fall to the high 20s or 30. But that's still a $55-60 stock right now.
Looking at long-term market P/Es of 12-15 is fine, but only in context of long-term corporate profit growth rates, which have been about 8%. For this kind of slow growth, a P/E of 12 relies on a time horizon of 9 years (without discounting cash flows). So, comparing this to THQI suggests that a P/E of 30-35 is perfectly reasonable right now. A P/E of 10 is certainly not reasonable, and I consider anything below $50 (P/E of 25) to be "unfair value" for THQI.
Using the same analysis, companies like DELL, MSFT and CSCO should have multiples of no more than 30-40 times trailing EPS.
Unfortunately, most stock market players don't consider this approach to valuation and investing these days. And that's why THQI rests at $20.
Todd |
