Recently Activision (NASDAQ:ATVI) hit record highs once again. It’s been certainly a rewarding stock for investors the past few years. Its optimism comes mainly from purchases of next-gen consoles and a seemingly never-ending bull market.

This stock is personal to me since it's the first one I ever purchased. I bought a few shares back then in 2011-2012, at an average price of somewhere around $11.50 per share. Since then the capital appreciation has been considerable.

At the time I was searching for value stocks and Activision was trading at a huge discount. The narrative was that the console market was aging and as a consequence, video game sales were slowing down. Also, we were just pulling out from the worst financial recession since the great depression, so investors were very pessimistic about the future.

Source: Activision Blizzard logo

It looked like a traditional value investment, and it checked all the boxes: a low PE, growing revenues, and steady dividends. Fortunately, it proved to be profitable for me even though I didn’t catch its run to 40’s. At the end I sold at $15 per share, resulting in a 30% profit.

Clearly, a rookie mistake, had I held until yesterday my profits would have been above 280% for about five years of holding. A very decent rate of return and a significant alpha over most index benchmarks.

However, in my defense, I think any value investor would have sold Activision somewhere along the way. I say this because its stock price has risen so much by now that it has become clearly overvalued. At best, it’s fair to say that it is on the expensive side.

P/E RATIO VS EARNINGS AND REVENUES

Since I sold, there's been considerable growth in Activision's both bottom and top line. That's another lesson in taking profits too early. But regardless, the company’s results subsequently continued to be the following:

Source: Activision Blizzard annual SEC filings, 2016 Q3 updated outlook and author’s calculations.

The central question by now is: Can Activision's stocks continue to rise? To answer it, I'd like to direct the attention of the reader to the following takeaways from Activision’s guidance and my calculations:

· Revenue is expected to increase substantially for 2016, mainly from a blowout 4th quarter this holiday season. A lofty goal indeed.

· Earnings are expected to continue to tumble, forecasting a -27% decrease.

· The current PE ratio stands at 44.66, representing an earnings yield of 2.23%.

It's fascinating that even though Activision continues to expand its income statement's top line, its margins are getting tighter. In turn, this reduces net income for shareholders. It's fair to say that in the past management lead a leaner company concerning the process of converting revenues to earnings.

By the way, regarding earnings, another red flag I noticed from Activision’s management is the huge discrepancies between GAAP and non-GAAP figures. For example, last quarter GAAP EPS were $0.17 vs. non-GAAP EPS of $0.45. That's almost triple the GAAP numbers.

The difference between GAAP and non-GAAP came from the acquisition of King Digital Entertainment, and so Activision considers it as a one-time item. Because of this reason Activision thinks it shouldn't take it into account when reporting its numbers. But, regardless of its nature, is not an expense in any case?

Any investor performing due diligence before purchasing a stock should pay more attention to GAAP numbers rather than non-GAAP. Putting makeup on financial statements isn’t new, but it always seems to go in hand with the last stages of bubbles and bull markets. Caveat emptor.

IS ACTIVISION OVERVALUED?

By traditional measurements, it's rational to think Activision's investors may be getting ahead of themselves. Its market capitalization has risen considerably in a relatively short amount of time. In these cases, it's often a good idea compare the stock's earnings and revenues vs. its PE or PS ratios. This exercise will help the investor have a better idea about whether or not share price increases are justified by a corresponding growth in the underlying asset.

Source: Activision Blizzard annual SEC filings, 2016 Q3 updated outlook and author’s calculations.

As the reader can see, the company’s earnings have been falling in 2016 and are expected to decrease by -27% according to GAAP guidance. On the other hand, revenues continue to grow, and management forecasts a substantial increase by the end of 2016.

It's worth mentioning that at Activision's current market cap of $33 billion, $653 million in earnings would represent a PE of 50. This PE is higher because earnings by then will be even lower than what they are at the moment.

Just to put that figure in perspective, if you had $33 billion and were able to buy the whole company at its current price, then you’d have to wait 50 years just to break even on your investment. Of course, that’s assuming earnings don’t continue to fall. If earnings were to start ticking upwards, then the number of years you'd have to wait would decrease accordingly. But even then half a century just to break-even is too much.

Even if earnings doubled you’d still have to wait a quarter of a century just to recoup your investment. Talk about irrational exuberance.

Incidentally, behind the reported numbers, we can have a glimpse into the market’s reasoning when pricing Activision’s stock. It’s evident that its PE ratio correlates strongly with the growth rate of the company’s revenues, rather than its earnings.

Source: Activision Blizzard annual SEC filings, 2016 Q3 updated outlook and author’s calculations using MINITAB 17 statistical software.

We can observe that it's statistically significant the correlation between Activision’s PE ratio and its revenues. And so if revenues increase, then its PE ratio should follow suit. Naturally, it's important to remember the first rule about correlations: They don’t mean causality. Also, the sample is small, so take this finding with a grain of salt.

Nevertheless, the conclusions one can draw from this insight are the following:

· The market is evaluating Activision like the average tech stock because it’s ignoring its earnings as long as revenues continue to grow. Most likely, hoping that it will be able to improve margins and increase its bottom line.

· As long as the market values Activision in this way and revenues continue to grow, any increase in income should mean an increase in share price.

This relation might seem obvious at first, but its implications are quite amazing, and fit with the way the market tends to value tech stocks.

WILL REVENUES CONTINUE TO INCREASE?

Revenues are easier to predict. I think the biggest factor for predicting sales is the company’s primary market, and whether or not it’s undergoing secular growth. In Activision's case, the gaming market has experienced a considerable expansion, and this trend is expected to continue.

Source: Newzoo, graphic’s elaboration by Business Insider.

As the reader can see, the gaming market is growing at a very healthy pace. This year is expected to reach $100 billion. Since Activision in its guidance projected revenues to reach $6.4 billion in 2016, I calculate its market share to be around 6.4% of the total.

Also, it’s worth mentioning that we can expect the majority of the gaming market to come from the mobile segment. In this context, the acquisition of King Digital Entertainment is a savvy move for future growth since that sector is likely to develop the most in the following years.

More remarkable still is the fact that the gaming market will grow by 8% in 2016, but in the same year, Activision's revenues are expected to increase by a whopping 37%. In other words, the company is gaining market share in the overall gaming market to the tune of 1.4%, from 5% in 2015 to 6.4% in 2016.

IMPLICATIONS

I’ve prepared the following table using the data from Newzoo about the overall gaming market. Also, I assume that Activision’s market share will continue to remain the same through the next few years. When predicting it’s earnings I used the same margin from the company’s guidance for 2016 and multiplied it by the resulting calculated revenues.

Lastly, I used the regression model from the correlation I found between Activision's PE ratio and revenues and estimated the company's future stock price. I can do this because by now I've forecasted its revenues, earnings, and PE ratio.

Source: Activision Blizzard annual SEC filings, 2016 Q3 updated outlook, Newzoo gaming market forecasts and author’s calculations.

What I liked the most about these predictions is that the regression model managed to anticipate share prices for 2015 and 2016 with a high degree of accuracy because of its high r coefficient. What’s even more enticing is that it shows Activision’s stock can still increase in the coming years despite being already expensive.

Still, it’s evident that at the current price of $44 per share, there’s not much upside to justify an investment in this very high PE stock. Such stocks tend to get hit the hardest during market corrections, and so the investor’s exposure to systematic risk is not adequately compensated at these price levels.

Now that we have an idea about how high Activision’s stock price can rise given its anticipated future results, we can calculate the resulting compounded annual growth rate (CAGR) for a holding period of three years. In the following table, I provide different entry points to illustrate how the price paid now can impact the investor's overall return.

To determine a good entry point for investment in Activision's stock, we can calculate the CAGR (%) of the NASDAQ composite for the last three years and compare it to what we could expect to gain annually according to our regression model.

The results aren't very encouraging at the current market price for Activision because there would be little alpha over the NASDAQ composite. Even if the stock were to drop to $37.50, the resulting alpha wouldn't be something extraordinary.

If anything, it shows that at its current price, the investor would be better off taking profits rather than adding to his/her position. We can conclude this because it makes no sense for a rational investor to assume the inherent risks of a stock with a high PE ratio in exchange of an expected negative alpha of -1.4% over the benchmark.

In this case, the NASDAQ's PE is around 24.75, and Activision's PE is close to 45. Since the NASDAQ has yielded a CAGR of 12.2% for the last three years, there’s no reason for the investor to buy Activision’s stock at $45 and expect a CAGR of 10.8% over the next three years.

PROJECTED VALUATION

Using the forecasted data from our model and Newzoo’s projections, I've prepared the following graphic to illustrate to the reader how Activision's price and PE are expected to evolve in the coming years.

Source: Activision Blizzard annual SEC filings, 2016 Q3 updated outlook, Newzoo gaming market forecasts and author’s calculations.

Under this valuation, the following stands out:

· Upside in Activision’s stock is still respectable. I expect it to yield 10% annually over the next three years, despite being already expensive. But the investor will most likely not achieve alpha over the NASDAQ composite.

· Continued growth in revenue will remain the single most important factor regarding investment success in Activision’s stock.

· Growth in revenues is almost certainly going to keep increasing.

· I’ve prepared the graphic above assuming Activision’s margins don’t continue to deteriorate. However, this trend has been worsening for the past few years.

MARGIN OF SAFETY

When taking a value investment approach, it’s often suggested a margin of safety of around 50% when comparing the earnings yield of an asset vis-a-vis a safer alternative. In stocks, we use their corresponding corporate bonds, and in the case of Activision, those bonds are yielding around 4.4%[footnoteRef:1]. [1: https://fred.stlouisfed.org/series/DBAA]

With a predicted PE for 2016 of around 50, the earnings yield of Activision would be 2%, implying a negative margin of safety (overvalue) of 120%. Put differently, the biggest risk factor for shareholders in the event of a market pullback or a Fed rate hikes is that stocks with high PE ratios will get hit the hardest. Hence, Activision's stock would become a strong sell.

However, for the time being, the Fed seems to be holding off the hike. At this point, it's just something investors need to keep an eye out for during this period until their next meeting.

CONCLUSION

Despite the fact that from a value investing approach the stock remains overvalued, there's evidence that suggests that Activision’s stock still can rise in the coming years. Of course, this is barring any market shock type event and assuming ceteris paribus remains.

This conclusion makes sense when considering that growth stocks tend to keep rising, and despite being expensive, their development makes them attractive. In the case of Activision, it promises incredible expansion, and since the market is clearly optimistic in its valuation, further improvements will likely result in future share price increases.

All the same, at current price levels the potential upside in ATVI doesn't compensate the investor adequately for the inherent risks of investing in high PE stocks. It’s sensible to expect that its business will continue to expand. However, its over-extended valuation makes it a hold at current levels and even signals an opportunity to take profits.

Nevertheless, in the event of a pullback to $37.50, the stock would again become promising. The investor under these conditions would be reasonable to expect an alpha of close to 6% over the NASDAQ composite which isn’t extraordinary, but still attractive enough to consider buying.

As always, I’ll be happy to answer any questions or comments regarding the contents of the article. I sincerely hope the information above was of use to you.

Good luck everyone.

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