Is Gamestop Overvalued? – Conclusion

We’ve come to the end of this tutorial on Discounted Cash Flow analysis. Using Gamestop’s publicly available data, we have determined that Gamestop’s stock is worth $23.78 (I have used “we” throughout this tutorial, but of course you are welcome to get different results by modifying the model). Considering the stock at the time of the research as evidenced by the Introduction page was $50.29, it seems like a good investment to bet against Gamestop’s stock, or at least avoid buying it.

I’ll also reiterate that all the data and spreadsheets used for this tutorial are available for download so that you can tinker with it and read more information about Gamestop’s operations.

If you have any questions or comments, your emails to loganfrederick [at] gmail.com are welcome.

Is Gamestop Overvalued? – Extending the Research

The following aspects of Gamestop’s business were not thoroughly researched for this paper and should be to complete the analysis:

Leasing versus Ownership:

Gamestop uses a combination of leasing and owning for its retail locations and distribution centers. It is possible that the renewing leases could help or hurt Gamestop in some significant way or that the financing environment might affect how these leases are paid. Lease accounting is discussed in the 10K on page 35 and page 49.

Tax Rates:

The model uses a standard 35% corporate tax rate. Gamestop has some tax credits that can be used in the future to potentially help its earnings, but has also had some historical years with effective tax rates above 35%. These were not used in the model and should be to get a more accurate price.

Choosing a Different WACC:

After attempting to use comparable companies to Gamestop to select the model’s Weighted Average Cost of Capital, I set this value to 8% as it seemed the most reasonable. A more rigorous model for selecting the WACC involving different comparison companies or industry information could be used.

Better Methods for Modeling Future Sales

Despite all the discussion about what might affect Gamestop’s sales in the future, the model uses a simple method for growing and declining sales. The first couple projected years grow based on previous sales growth rates due to the launch of new game hardware. Then the last few years show steady sales decline based on the reasons given in the thesis.

A better, potentially more accurate method for estimating future revenue would include factors such as projected consumer spending patterns, more precise adjustments for the potential hardware and software sales with a new gaming generation (which could be determined using patterns from past generation launches), and other sector and economic factors.

Investigate the Increase in Selling, General, and Administrative Expenses:

Why has SG&A increased by $400 million in five years? This is the primary question which came to mind when building the model.

On page 38, Gamestop notes: “Selling, general and administrative expenses decreased by $6.2 million, or 0.3%, from $1,842.1 million in fiscal 2011 to $1,835.9 million in fiscal 2012. This decrease was primarily due to changes in foreign exchange rates which had the effect of decreasing expenses by $26.7 million when compared to fiscal 2011 offset partially by expenses for the 53rd week in fiscal 2012. Selling, general and administrative expenses as a percentage of sales increased from 19.3% in the fiscal 2011 to 20.7% in fiscal 2012. The increase in selling, general and administrative expenses as a percentage of net sales was primarily due to deleveraging of fixed costs as a result of the decrease in comparable store sales. Included in selling, general and administrative expenses are $19.6 million and $18.8 million in stock-­based compensation expense for fiscal 2012 and fiscal 2011, respectively.“

This does not explain the $400 million increase from 2008 to 2011. Although sales grew by approximately $700 million from 2008 to 2011, sales dropped in fiscal 2012 back to 2008 levels, while SG&A remained stagnant, presumably for the fixed cost/same-­store sales decrease reasons listed above. If revenue remains around the 2008 levels, it would be worth investigating if Gamestop could bring its SG&A costs down as well.

Next: Conclusion
Previous: Valuing The Stock

Is Gamestop Overvalued? – Valuing the Stock

In the Introduction, I mentioned that future estimates of a company’s profitability are inherently inaccurate because nobody truly knows what will happen in the future. Additionally, the farther into the future you try to guess, the less accurate your guesses will generally be. To compensate for this, financial analysts use the previously noted Time Value of Money principle to “discount” future Free Cash Flow (which we found in the last section). Discounting means that if we want to use future profits to determine the company’s value today, we have to make those profits less valuable because there is a chance the company won’t actually earn those profits in the future.

So the next question is: How much less should future cash flow be worth?

The common technique in finance is to apply a “Discount Factor” or “Discount Rate” to decrease the future cash flows.

The Discount Rate is an annual interest rate, except instead of going forward in time, you’re going backward in time from the future to the present (also known as the Present Value formula). The Present Value formula is:

Present Value Formula

In our Gamestop model below, we find the Present Value for every year into the future we have found Free Cash Flow (“Present Value of FCF” in the spreadsheet). “N” is how many years into the future.

What do we use as the discount rate (“r” in the equation)? This is where we use the Weighted Average Cost of Capital (WACC). A longer definition is in the Glossary, but the WACC represents the minimum expected rate of return an investor in the company would expect the company to earn with the investor’s money. Therefore, discounting by the investor’s minimum expected investment return turns future profits into their present value based on investor expectations.

How do we determine what the WACC should be?

There are some different ways to determine the WACC. In my case, I tried initially to find Gamestop’s WACC using data from similar companies, but the value this produced was too low. You can see this work if you download the Excel workbook and view the “WACC” spreadsheet. The lower the WACC, the higher the stock price, since you are discounting or decreasing the cash flows by this rate. So I manually set the WACC at 8% in the model, which seemed realistically fair.

Applying the Present Value formula onto each future year’s FCF gives us the “Present Value of Free Cash Flow” row in the Excel model.

Free Cash Flow

Finding Enterprise Value:

With the knowledge of what the company’s future profits are worth to us today, we can determine how much the company is worth. The company’s value is called the “Enterprise Value”. Again, a longer definition of Enterprise Value is in the Glossary. Here we can define the Enterprise Value as the sum of the Present Value of Free Cash Flows (in the spreadsheet as “Cumulative Present Value of FCF”) plus the Terminal Value.

The Terminal Value represents the value of the company for all the years beyond our model combined into one amount. This can be determined in different ways. In my model I chose to use the “Perpetuity Growth Method.” Simply put, this takes the last year’s Free Cash Flow in the model and grows it at a small rate indefinitely into the future and then discounting it back to its present value. The Terminal Value requires choosing a “perpetual growth rate”, also known as the rate at which the company will grow forever into the future. This percentage should be low as it’s impossible for company to grow faster than the entire economy forever. For Gamestop, I chose a one percent perpetual growth rate. Based on the Thesis and Supporting Arguments, I do not believe the company will grow very fast in the future, but I did not choose zero growth to keep my model a little more conservative and assume that Gamestop will not go completely bankrupt.

Adding the Cumulative Present Value of FCF and the Terminal Value gives us the Enterprise Value. Congratulations, you have now found the value for the entire company! In my model, I determined that the entire Gamestop company is worth approximately $2.357 billion.

The Final Steps – Finding the Stock Price:

Next we will take the value of the company and determine how much each share of stock gets of that value. Adding the Enterprise Value plus the company’s cash gives us the Equity Value, which is the value of the company which belongs to the shareholders. Gamestop has $635 million of cash in the bank, so added onto the Enterprise Value gives Gamestop an Equity Value of $3.006 billion.

The formula for the stock price is:

Stock Price=Equity Value/Fully Diluted Shares Outstanding

Fully Diluted Shares Outstanding is the number of all the company’s stock. To reiterate in English, the stock price is the total value of the company and its cash divided by the total number of shares of stock that exist. FDSO is the “Shares Outstanding” (shares available in the market) plus new shares of stock that can be created by stock options in owned by the company and its employees.

Gamestop has 126.4 million shares of stock.

Take Gamestop’s $3.006 billion in Equity Value divided by its 126.4 million shares and you find that every share of stock is worth $23.78.

Next: Extending the Research
Previous: The Future

Is Gamestop Overvalued? – The Future

Now that we’ve discussed the business, potential problems, and historical financial performance of Gamestop, we can attempt to predict the future to determine if the stock is under-, over-, or correctly valued in the stock market.

Below is the second half of the DCF Excel spreadsheet with the future projections for Gamestop’s financials and projected Free Cash Flow, followed by an explanation of how these numbers were found.

GME Future

Future Sales: In your typical DCF model, you can just grow sales every year into the future using the average growth rate I list in cell G3 in the above spreadsheet. In reality, business rarely have revenue every year change by the same amount. Specifically with Gamestop, I chose to have temporary high growth in the near future because of all the new video game consoles being released in 2013 and the pent up videogame demand saved up for this occasion. However, for all the reasons listed in my “Supporting Arguments”, I decrease the company’s revenue in the future. For the specific percentages, I used Gamestop’s best and worst annual growth rates in the past five years.

Cost of Revenue and SG&A Projections: To find Gamestop’s future Earnings Before Taxes, Interest, Depreciation and Amortization, we need to subtract out its future Cost of Revenue and SG&A costs. To predict those costs, at the bottom of the spreadsheet I have included some extra information: The Cost of Revenue growth rate taken from the CAGR column and SG&A as a percentage of Revenue. SG&A as a percentage of Revenue is based on the average ratio of SG&A to Revenue from past years and using that average ratio in the future.

GME Other Variables and Ratios

Depreciation and Amortization: Future D&A was set at 2% of future revenue. This is another standard number that you could try and modify if you see major changes in these expenses, but I did not see such reasons. If you compare the future projections of D&A using this “2% of future revenue metric”, you will see it is relatively close to the past values and thus seems like a reasonable assumption.

Capital Expenditures: Future Capex was set at 1.85% of future revenue, which was the average Capex over the previous five years.

Increase in Net Working Capital: This is the most complex part of the Free Cash Flow equation, so I have dedicated a separate post to explaining the details on how to project future changes in Net Working Capital.

The equation for Free Cash Flow is:

EBIAT
+ D&A
– Capex
– Increase in Net Working Capital
=Free Cash Flow.

The reason this works to find the company’s available cash flow:

EBIAT represents the company’s earnings that could be used to pay off any debts in the event of a liquidation (hence why “Interest” is not taken out, interest comes from those debts).

Capex is subtracted because it is a use of the company’s cash. Even though it can be considered cash spent wisely to improve the business, it is still less cash available to the owners (the stock holders).

The Increase in Net Working Capital is subtracted because an increase in NWC, like Capex, means cash has been used to either increase the company’s assets or decrease its liabilities. Both of these are not strictly good nor bad, but they are uses of cash that are not available for the investors to pocket.

However, the remaining cash is available for investors.

Using the steps and descriptions above for each row in the Excel spreadsheet model and every column representing the next five year’s of the company’s operations, we can use the simple math explained above and in the past to estimate future Free Cash Flow.

With our guesses for the company’s future profits, we can now determine what the stock price should be.

Next: The Future
Previous: Net Working Capital

Is Gamestop Overvalued? – Net Working Capital

Increase in Net Working Capital: Increase in Net Working Capital is the most complicated of our future projections. This is because to properly find future NWC, you have to predict future Current Assets and future Current Liabilities.

To accomplish this, I added a “NWC” spreadsheet to my Excel workbook:

GME Net Working Capital

All of the numbers in the 2008 through 2012 columns were taken from the 2008 through 2012 Gamestop Balance Sheets. The projections for the 2013-2017 values are found by taking the average growth rates or most recent value for the assets and liabilities and using those values or rates in future years.

The spreadsheet provides a visual for what makes up Current Assets and Current Liabilities. In English, they are:

Current Assets:

Accounts Receivables: Amounts owed to the company for products or services it has given on credit to other business or individuals.

Inventories: Inventories are the company’s raw materials and products made or in the process of being made.

Prepaid Expenses: These are expenses paid by the company before receiving the products or services for which it has paid. An example of a prepaid expense is an insurance premium which is paid completely upfront but covers a company or person for some amount of time such as a year. The insurance is a prepaid expense which initially is an asset that will get used over the course of the year, decreasing the asset over that time.

Cash and Cash Equivalents: The company’s cash and assets that can almost immediately be turned into cash, such as commercial paper and Treasury Bills.

Other Current Assets: Assets that do not fall into the above categories but are still assets that can be turned into cash within a year. These kinds of assets are typically non-recurring or not large enough to require their own category on the balance sheet. Some examples of this could be cash paid in advance to suppliers or employees that is accounted separately from the rest of the company’s cash or small investments in other companies or assets the company has made.

Current Liabilities:

Accounts Payable: Payments owed to the company for products or services already provided to a customer. This can be thought of in non-accounting terms as customers’ unpaid bills.

Accrued Liabilities: Expenses such as salaries, rent, interest, and taxes that the company owes but has not yet paid.

Other Current Liabilities: Other types of liabilities that don’t fit into one of the other categories, possibly don’t occur very often, and are due to be paid or worked off within a year.

Assumptions:

Day Sales Outstanding (DSO): DSO tells you how a company is managing its Account Receivables. The lower the number, the faster the company is getting paid by its customers. The equation for DSO is: (AR/Sales) * 365.

Days Inventory Held (DHI): DHI tells you how a company is managing its Inventory. The lower the number, the faster the company is selling or getting rid of its old product inventory. The equation for DHI is: (Inventory/Cost of Revenue) * 365.

Prepaids and Other Current Assets as a Percentage of Sales: This percentage is used to project the Prepaid and Other Current Assets into the future by setting them to a percentage of the future Revenue.

Days Payable Outstanding (DPO): DPO tells you how long it takes a company to pay its suppliers. The larger this number, the longer amount of time the company is taking to pay its suppliers. A larger number is good because it means the company is not rushed to pay its bills and has time to invest its cash into other parts of the business before having to pay bills. The equation for DPO is: (Accounts Payable/Cost of Revenue) * 365.

Accrued Liabilities as as Percentage of Sales: This percentage is used to project the Accrued Liabilities into the future by setting them to a percentage of the future Revenue.

Other Current Liabilities as a Percentage of Sales: This percentage is used to project the Other Current Liabilities as a percentage of the future Revenue.

Is Gamestop Overvalued? – Starting the DCF Model

Now that we’ve highlighted the important vocabulary used in Discounted Cash Flow modeling, we can build a model for Gamestop.

The goal of the DCF is to find the value of the company based on its future profit discounted at some rate to factor in the uncertainty of those profits. This “value” is called “intrinsic value”, which is different from the “market value” of the company. In the marketplace, anyone can buy the company or its stock for whatever someone is willing to sell to them at a “market price”. This can be unrelated to how much money the business actually makes.

The key points to remember are that although the market value can be unrelated to the health of a business, it can be easily seen in the market. The intrinsic value is how much a company is actually worth based on how much money it will make, but predicting the future is harder to see.

Given the information that companies are required by law to publish about themselves (the accounting statements in SEC filings), how can we divine the intrinsic value of a company?

This is done by taking the company’s revenues and removing all of the expenses that affect its cash until you are left with the Free Cash Flow. Finding how much cash a company makes is vital to its intrinsic value.

To get the actual numbers to plug into the DCF, we pull from the publicly published accounting statements.

In arithmetical terms along with the accounting statements where the data can be found, the DCF formula is:

Revenue (*Income Statement*)
-Cost of Revenue (*Income Statement*)
=Gross Profit
-SG&A (*Income Statement*)
=EBITDA
-D&A (*Income Statement*)
=EBIT
-Taxes (*Your Choice or Income Statement*)
=EBIAT
+D&A (*Income Statement*)
-Capex (*Cash Flow Statement*)
-Increase in NWC (*Balance Sheet*)
=Free Cash Flow

The DCF model is generally built using annual data, so taking these data points from one year’s SEC filings will give you one year’s Free Cash Flow.

But the company’s intrinsic value isn’t really determined by what happened in the past! What we want to know is how a business will do in the future after we’ve invested our money. As I pointed out in the introduction, we obviously don’t know the future, so the best we can do is use past performance, along with our educated guesses (hence the thesis and researched supporting arguments), to predict the future.

In a typical DCF model, you will want to run the above Free Cash Flow formula on multiple previous years, taking your data from those years’ publicly available financial paperwork. I have done this for Gamestop using the years 2008-2012 (the numbers are measured in millions):

GME DCF Past Data

Some things to point out from this historical data:

  • While revenue growth between 2008 to 2012 was almost flat (rising until 2011 then falling dramatically in 2012, possibly due to consumers waiting for the new gaming systems), SG&A expenses rose by $400 million over this period.
  • EBIAT has decreased from 2008 to 2012.
  • Capital Expenditures decreased from 2008 to 2012, which helped free up cash for the shareholders but could also signal decreased investment back into the business.
  • Despite the increase in SG&A and flat Earnings metrics, Free Cash Flow has more than doubled over the past five years, a good sign for stockholders.

On the far right I have included a column with the Compound Annual Growth Rate (CAGR) of the various financial data to show how these parts of the Gamestop business have grown over the past five years. We can use these growth rates to attempt to predict into the future, along with our own modifications based on our beliefs in the future of the business.

Next: Net Working Capital
Previous: DCF Glossary

Is Gamestop Overvalued? – DCF Glossary

Before walking through the model, here is a glossary of common accounting and finance terms that will be used throughout this blog series:

Sales/Revenue: Sales or Revenue is the total dollar amount a company has “realized” (received) through the sales of its products and services during a given time period.

Cost of Goods Sold/Cost of Revenue: These are the costs directly associated with producing the company’s products or services, which include the cost of materials used and the labor of making the product or doing the service.

Gross Profit: The profit earned by a company after subtracting the costs directly related to producing its products or services. This can be used as an indicator of the company’s efficiency and for determining gross profit margins.

Selling, General, and Administrative Expenses: These are expenses a company incurs that are required to run the business but not to directly make an individual product or service. Basic examples of this are building rents, utilities, and administrative and sales employee salaries.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): A common metric for operating cash flow since it reflects the company’s total cash operating costs for producing its products or services. It is also important for comparing companies in the same industry against each other because EBITDA is free from the differences companies have in the “capital structure” (whether a company is funded by stock investment or debt, and the interest expenses that come with debt) or tax rates. If this is not given by the company, it is calculated by taking the company’s reported “EBIT” number and adding back in Depreciation and Amortization. These are added because they are not cash expenses (cash was spent at some point in time, but not on a continuing basis). This is a non-Generally Accepted Accounting Principle measure, but is commonly used by companies and financial analysts.

Depreciation and Amortization: These are two methods for decreasing the value of an asset because it has been partially used. The layperson example of depreciation is of an individual’s car losing value after buying and driving it because the car has been used and is therefore older and potentially more “worn down”. Companies have assets which they depreciate in a similar manner. Amortization is reducing the value of an “intangible asset”. An layperson’s example of this is an “amortizing home loan”, where the loan’s principal value decreases steadily with each mortgage payment. While the house might be an asset, the loan is what is being paid, and financial instruments like loans can be considered “intangible”.

Earnings Before Interest and Taxes (EBIT, also known as Operating Income, Operating Profit, or Operating Earnings): The reason EBIT is also called Operating Income because it is the measure of a company’s profit after all its operational expenses (the SG&A, Depreciation, Amortization, and Cost of Goods Sold) that are part of earning its revenue are subtracted from its revenue. The only expenses left are interest on debt and taxes, which do not directly affect the business’s operations except as final expenses.

Taxes: The taxes applied on a company’s earnings. Typically for basic modeling purposes analysts will use 35% to 45% tax rates, but companies will give more detailed tax expenses or credits in their public filings.

Earnings Before Interest After Taxes (EBIAT): Earnings after taxes is sometimes used as a metric for comparing companies, but less so compared to EBITDA. Taxes are taken out because they are an expense that company’s have little influence on compared to the rest of their business and so are considered not highly relevant when trying to figure out how healthy a business is.

Capital Expenditures (CAPEX): A capital expenditure is an expense used to acquire or improve a company’s assets, such as building new factories and buying equipment. These expenses are made with the intent of growing the business. This is found in a company’s Cash Flow statement.

Current Assets: Current Assets are non-cash assets that can be used or turned into cash within a year, such as Accounts Receivable (payments due from customers to the company) and Inventory. This is found on the Balance Sheet.

Current Liabilities: Current Liabilities are liabilities that need to be paid or settled within a year. This is found on the Balance Sheet.

Net Working Capital (NWC): This is a company’s “Current Assets” minus “Current Liabilities”. This shows how much cash and other liquid assets a company uses to run its operations. One important point is that an increase in NWC is a use of or decrease in available cash because the cash is being turned into assets like inventory used to grow the business. A decrease in NWC is either caused by assets being used up to generate cash or liabilities decreasing, and is therefore an increase or source of cash.

Free Cash Flow (FCF): This is the cash left over after all the expenses of running the business have been removed from revenues. Free Cash Flow is what companies use to grow the business, save for a rainy day, or give money back to shareholders.

Weighted Average Cost of Capital (WACC): Companies are funded by some mix of equity (stock ownership) and debt. Investors who either buy the stock or give the company loans expect some return on their investment. The “cost of capital” is financial jargon for an investor’s expected return. Because stock and debt are have different legal and financial arrangements between the company and investors, they have different costs. A lot of public companies use a combination of stock and debt, so you have to find an average between the cost of stock and the cost of debt to the company. The equation for the Weighted Average Cost of Capital is:

WACC Equation

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
T = corporate tax rate

Tangible Book Value (Per Share) (TBV): Tangible Book Value is the value of the company if it had to sell off all its tangible assets at the value of those assets in its accounting books. “Intangible” assets like trademarks and brand recognition are not included because, in a situation like bankruptcy where a company has to sell all its assets, intangible assets would have no or unpredictable value. If a company supplies its TBV data (which they typically do), it will appear on the Balance Sheet. TBV per share is the company’s TBV divided by the number of shares of stock, telling each shareholder how much of the company’s value his stock is worth.

Terminal Value: The value of the company as an ongoing business. In the context of a DCF model, it’s the value of all the potential future profits outside of the immediate years in your model.

Perpetuity Growth Rate: The annual rate at which the company’s terminal value will grow indefinitely into the future. This is a way to factor into your model the expectation that the company will continue to grow and this growth should be considered when valuing the business. This percentage is rarely more than 3% per year, which is the target for annual growth of the USA economy as a whole.

Enterprise Value: The value for the entire company. The equation for Enterprise Value is: Value of all the common stock (called “market capitalization”) + value of preferred stock (often given to special investors or founders/managers of a company) + value of debts + Minority Interests in Other Business – Cash and cash-like assets.

Next: Starting the DCF Model
Previous: Supporting Arguments