gme logoBy Adib Motiwala of http://adibmotiwala.blogspot.com/

Let us look at two popular stocks among investors (both long and short).

Lets start with Netflix (NFLX). Netflix, Inc. provides online movie rental subscription services in the United States. You can rent movies in the form of DVDs that are mailed to you and you can also view movies via streaming on your PC or a host of other devices such as XBOX, PS3 etc. Netflix is clearly a great brand and is loved by its 12 million plus customers. Netflix has also made a lot of money for its shareholders.

Gamestop (GME) is the largest video game retailer in the world. It operates more than 6500 stories in the US, Canada, Australia, UK, France and other European countries. Gamestop is a popular destination for gamers to get their hands on the latest games and consoles as well as trade their used games.

Let us look at some of financial metrics for Netflix and Gamestop

Netflix (NFLX) Gamestop (GME)
Share price $118.39 $18.95
Market Cap 6190 million 2870 million
Enterprise Value 6160 million 2890 million
P/E 53.6 8.2
P/ FCF 22 5.8
EV / OCF 19 4.4
EV / EBITDA 24.5 3.6
P/S 3.5 0.3
P/B 42 1.1
PEG Ratio 1.8 0.7
Revenue 1770 million 9180 million
EBITDA 251 million 802 million
Net Income 126 million 382 million
5 year avg revenue growth 27.5% 40%
5 year avg EPS growth 47% 35%
5 year Operating margin 7% 7%
5 year average ROE 26% 15%
5 year median FCF growth 20.5% 27.7%
Short % of float 22.5% 18.8%

From the market cap, you will notice that the market values Netflix as more than twice GameStop.

Next, look at the valuation metrics. On a P/E basis, Netflix is valued at almost 54x earnings while GameStop trades at a low 8x earnings. If you run down any other valuation metric be it cash flow, free cash flow or the EBITDA multiple, Gamestop is trading at a very cheap valuation compared to Netflix. Clearly, the market thinks Netflix deserves this high multiple and Gamestop deserves a low valuation. However, if you look at the 5 year average revenue growth, you see that Gamestop has been ahead of Netflix. Netflix is ahead on the 5 year earnings growth. However, when it comes to operating margins, Netflix does not have any better margins than the retailer that is Gamestop.

One reason everyone loves Netflix is due to the imminent death of BlockBuster. Even though there is growing competition from RedBox and its DVD renting kiosks which are mushrooming all over the country this has been ignored. The same rules do not apply for Gamestop however. BestBuy has recently announced that it will attempt to buy and sell used games once again in its stores. And then there is the threat of digital downloads, streaming games via Onlive, games sold at Walmart, Amazon, Ebay etc etc.

I employ the Discounted cash flow valuation method (DCF) to see what is priced into the stock. Of late, I have been using DCF in a non-traditional fashion. Rather than trying to predict cash flows, I enter in the growth rate and discount rate that will give me the intrinsic value as the current stock price. This lets me see the expectations built into the stock or Price implied expectations (PIE). I use a standard 12% discount rate for all such computations.

Netflix has to grow FCF at 19.6% per year for the next 10 years to justify its current stock price. Now, Netflix was able to grow its FCF at a median rate of 20.5% over the last 5 year period. However, over 10 years this drops to a rate of 8% growth. If Netflix were to slow down its FCF growth rate to 8%, then the intrinsic value is $65. (a potential drop of 45% )

In the case of GameStop, if FCF were to reduce by 8% per year for the next 10 years then I would arrive at the current stock price. If however, FCF can grow just at 1% for the next 10 years then I arrive at an intrinsic value of $28. (potential gain of 47%). I am not even using the past 5 year and 10 year FCF growth rate of Gamestop which was much higher than 1%.

Conclusion: Netflix does not appear cheap by any traditional valuation measure. Employing reverse DCF shows us that extremely high FCF growth has been priced into Netflix to justify current prices. Netflix is clearly a high expectations stock. The potential downside is much higher than the potential upside.

Gamestop on the other hand is trading cheaply by any of the valuation measures. Employing reverse DCF confirms this valuation where a negative FCF growth rate is priced in at current prices. Gamestop is clearly a low expectations stock. The potential downside is much lower than the potential upside.

The interesting part is that a large % of the shares of both companies are trading short. Netflix short is at 22% and Gamestop is at 19%. A lot of investors and traders are betting that Netflix and Gamestop should trade down. I can understand shorting a high valuation and high expectation stock such as Netflix trading at 50x earnings. However, shorting a stock at 8x earnings is beyond me. I guess the market thinks that Gamestop should not exist or is worth much less.

Disclosure: I am long Gamestop via shares and call options at the time of publishing this post. I do not have a position in Netflix currently. My positions may change at any time without any further updates. Please conduct your own research before considering investments based on these or any ideas on this blog. This post is to be considered as my research and not advice or a recommendation to buy or sell any of the stocks discussed.