- Multiplayer, online role-playing games are one of the hot trends in electronic gaming and provide every indication of being here to stay.
- How to recognize the value in the stock even if you do not use or care about the products.
- Perfect World Company is either cheap, dirt cheap or stupid cheap depending on how you calculate the value.
Most stocks in trendy industries carry valuations that tend to run from reasonable to very expensive. As a value investor, I am not used to finding companies in “hot” industries that come anywhere close to meeting my standards for compelling value. However, exceptions to the rule do occur and I believe I have found one today in shares of Perfect World Company (PWRD, Financial). Perfect World Company is a developer and operator of multiplayer, role playing online games and markets their products primarily in China and the United States, but they are also available on an international basis. Its game catalog includes titles such as Perfect World, Legend of Martial Arts, Perfect World II, Zhu Xian, Chi Bi, Pocketpet, Journey West, and Forsaken World.
If these game names do not sound familiar to you, it could mean that you are not a serious participant in online gaming, or that you don’t spend a lot of time playing games based in China if you are. I am not personally a big fan of electronic games and have never played a multiplayer, role playing game online, so I really do not understand the allure of this particular activity. Normally, I like to understand why the customers of a business want or need its products or services. In this case, I am willing to overlook my lack of understanding of the desire for the products because of my confidence in my ability to identify a compelling investment opportunity when I see one, and I know that these types of games are very popular and, I am told, can be almost addictive.
How can you have confidence in a product you don't understand?
When I am considering an investment in a business that provides products I do not use and have little understanding as to what makes them attractive to the customers, I review the growth history of the business. It is really unimportant whether I have an interest in using the products or services of a company in which I invest as long as its customers do.
| Year Sales/Turnover (Net) | 2013 502.6 | 2012 445.5 | 2011 470 | 2010 371.5 | 2009 314.1 |
| Change from previous year | 12.8% | -5.2% | 26.5% | 18.27% |
The sales figures shown in the table represent millions of dollars and are taken from the company’s financial statements. Through the first three quarters of 2014, the company has generated $452.1 million in revenue and is currently projecting approximately $162 million for the fourth quarter, which would bring in 2014 revenues 21.8% higher than 2013 at $614 million.
While the company has not exhibited explosive growth in revenue, it has marched forward at a reasonably steady pace and appears to be on track to continue that growth this year. It seems that the company has been able to attract an audience for its gaming products and has demonstrated the ability to expand that audience at a stead, if not blistering, pace.
How is Perfect World currently valued?
On Tuesday, Perfect World’s shares closed out the trading day at $14.87/share. Based on this year’s consensus earnings estimates of $2.00/share from the analysts covering the stock, that translates to a P/E ratio of just 7.58. This is about 15% below its 5-year average of 8.95 and 74.47% below the industry average P/E of 29.69.
Return on equity is another good metric to use in establishing fair value of a business as it measures the rate at which the value of the shareholders' portion of the business is growing. From the end of 2009 through the end of 2013, Perfect World has increased shareholder equity from $336.4 million to $736.1 million, an annualized return of 21.62%. This is a superb rate of return in a zero interest world. It means that each dollar you have invested in the company has increased in intrinsic value by an average of 21.69% each year over the past four years. From the end of 2009 through the end of the third quarter of 2014, the annualized return on equity has been 19.32%.
Based upon these measures, Perfect World carries a very reasonable valuation compared to its industry and the management team has done an excellent job of increasing the intrinsic value of the portion of the business owned free and clear by the shareholders.
What is the real value of Perfect World? Is it cheap?
There are about as many ways to value a business as there are people performing the task. Unless there is some sort of compelling reason to apply additional metrics, I like to keep my approach fairly simple. While I understand the investment world mantra that past performance does not guarantee future results, I also understand that talented management does not lose the ability to produce exceptional results overnight. Therefore, I believe a business can be fairly valued based on past history and as compared to its industry.
In the case of Perfect World, this business appears to be cheap at first glance. The current P/E ratio of 7.50 is 74% below the industry average for software companies and about half the market average for the current year. Analysts covering this stock are projecting that the earnings will expand at an average of 18.3% over the next 5 years; so, the business is trading at a Price to Earnings Growth multiple of about 0.42. A PEG of 1 to 1.5 is normally what I consider to be a fair valuation for a business when the projected growth rate for earnings is 15% or more.
Based on these numbers, Perfect World appears to be cheap and currently trading at a price that would allow for 50% to 100% upside for the stock over the next 12 months without it becoming overvalued.
Could the stock be even cheaper? Could it be dirt cheap or less?
It is almost always a mistake to look at a couple of simple, straightforward numbers like these and try to assign a “fair value” to a business. After all, a business can have what appear to be favorable valuations, but be saddled with massive debts or high interest payments on debt. In order to ascertain whether there could be financial problems lurking just below the surface of a business, we need to review the balance sheet.
For this review, I want to look at the most recent numbers available as they can change quickly. In the case of Perfect World, the balance sheet is available for the quarter that ended on September 30, 2014 and it reveals something I was shocked to find on the books of a business trading at this kind of market capitalization. The company has cash and short-term investments of $592 million and receivables of $49 million. This cash mountain of $641 million equates to a staggering 85.2% of the company’s total market value. A business trading for $14.85/share is actually holding cash and receivables equal to $12.89/share and over 90% of that figure is in cash and short-term investments! Talk about a margin of safety! This leaves a stock price, net of cash and receivables, of only $1.96/share for a business expected to earn $2.18/share in 2015. A P/E ratio of 1? Really?
If we are going to consider cash and receivables in our calculation of fair value, it is only reasonable to also evaluate the total liabilities of the business. In this case, the company has total liabilities of only $428 million. Subtracting the total liabilities from the balance of cash and receivables leaves a net cash balance after liabilities of $213 million or $4.28/share. This lowers the actual cost of the shares to $10.57/share or approximately 5.25 times 2014 earnings and zero liabilities.
If I wanted to buy this business, instead of just buying some stock, I could. The market capitalization of the business today is $752.29 million. If half of the cash and receivables ($320 million) were used as a down payment, I would need to borrow about $435 million. If I issued bonds or put together a syndicated load at 8% interest to cover the difference, it would cost me $34.8 million/year to service the debt. The business is projected to earn just under $100 million in 2015 which would leave about $65 million in cash available to pay down the principal on the loan and a nice dividend for the last remaining shareholder…………me. With these kinds of numbers, the financing could be paid off in 10 years while I paid myself about $22 million a year in dividends and let the existing management group continue to run the business.
How is the stock currently valued compared to its history?
Statistically speaking, all things return to their average. After all, that is how it becomes the average. I like to look at historic valuations of a company compared to current valuations as just a last check to see if the business is cheap or expensive compared to its average valuation. As indicated on the chart below, in the case of PWRD, the stock is trading to the lower end of its historic P/E range and below the meidan P/E for the stock. This indicates to me that the stock should have more of a tendency to rise than to fall.
Final thoughts and actionable conclusions
This is not a cheap business; nor is it a dirt cheap business. The only way to describe this business is stupid cheap. This kind of value doesn’t come along every day and they do not tend to last long when they do. This stock could double or triple right now and still carry a reasonable valuation. It presents a rare opportunity to acquire a stock with a real shot at delivering triple digit returns in the next 12-18 months.
Buy it now anywhere under $16/share and sell half your position when you have a 100% gain and half of the remaining shares when you have a 200% gain. After that, place a trailing stop at 15% below the highest closing price and wait for the market to close you out.
One last thing I almost forgot to mention: While you are waiting to receive the enormous capital gains to come, you will also be rewarded with a $0.48/share dividend payment that produces a yield of 3.17% based on the current share price and is paid in April each year.
