With the upcoming holiday season promising to bring new products like the Xbox One and PlayStation 4, GameStop (NYSE:GME) would appear to be a desirable idea. However, at Valuentum, we think GameStop is overvalued - and here's why.
Our approach involves a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy.
This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. If a firm is undervalued both on a discounted cash-flow and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale.
By comparing the chart below with the one above, one can see that GameStop is now at the place where momentum investors are starting to drive the company's share price higher. We'll get to this in a bit, but we think GameStop's shares are also overvalued (price > fair value), which results in one of the worst possible scores on the Valuentum Buying Index rating system.
- GameStop earns a ValueCreationTM rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 162.5% during the past three years.
- GameStop is the world's largest multichannel video game retailer. The firm generates the majority of gross profit from used video game products. We think a decline in long-term profitability is inevitable.
- GameStop's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 4.8% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. The firm had no debt at the end of last quarter.
- Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
- Though GameStop boasts a hefty dividend yield, risks regarding the elimination of used game sales and physical distribution could be devastating to future profits.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. GameStop's 3-year historical return on invested capital (without goodwill) is 162.5%, which is above the estimate of its cost of capital of 11.8%. As such, we assign the firm a ValueCreationTM rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
We think GameStop is worth $32 per share. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRiskTM rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $32 per share represents an implied EV/EBITDA multiple of about 4.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -0.7%. Our model reflects a 5- year projected average operating margin of 7.1%, which is above GameStop's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of - 1.8% for the next 15 years and 3% in perpetuity. For GameStop, we use a 11.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRiskTM rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for GameStop. We think the firm is attractive below $21 per share (the green line), but quite expensive above $43 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate GameStop's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right compares the firm's current share price with the path of GameStop's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $42 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and should not be considered solicitation to buy or sell any security.