Part one is here.
Part two is here.
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Assistant: Mack Agbayani
Gabe Terracciano, Shnabubula – Metroid ‘Suite for Violin and Piano’
JD Harding – F-Zero ‘Muted Skyline’ http://ocremix.org/remix/OCR00285
Jakerno, The Key to Progression, Timo Majersky – Pokémon Red Version ‘Out of the Palace’ http://ocremix.org/remix/OCR02236
FFmusic Dj, Geoffrey Taucer – Super Mario 64 ‘Dire on the Rocks’ http://ocremix.org/remix/OCR03183
Pokérus – Pokémon Gold Version ‘New Horizons’
Dale North – EarthBound ‘Home Again’ http://ocremix.org/remix/OCR01545
What’s the deal with this graph? Why are Iwata and company spending even more on a new console? As it turns out, Nintendo isn’t using licensing and merchandising to evolve or at least diversify away from its traditional game system business, but rather as a way to get people to buy more of its software and hardware.
Upon announcement of Nintendo’s theme park venture with Universal, Iwata commented that Nintendo’s main goal with such ventures would be to “maximize the use of Nintendo’s intellectual property… and to attract new customers to the consoles and software, rather than to generate new revenue from licensing.”
Perhaps one reason why they are doing this is because, after all, it is Nintendo’s software and hardware that bring the company its sales volume, over and above licensing. For example, Iwata once mentioned that Nintendo’s mega-popular Amiibo figures, which are figurines based on Nintendo characters that provide gaming content, wouldn’t be a strong revenue driver given low unit prices versus games and game systems.
Okay, so traditional games and game systems will be at the core of Nintendo’s strategy going forward. Furthermore, since Nintendo’s mobile and NX press releases last March, news and rumors have abounded, adding more clues as to what Nintendo might planning. While we’re not going to talk about all the rumors, we will consider patents that Nintendo has filed, along with speculation published in sell-side research from Macquarie. (By the way, if you want to know more about what sell-side research is, please read our webcomic, Ilusion) Anyway, we’ve put together the major developments in what might be Nintendo’s strategy in this chart:
First, according to the Wall Street Journal, the NX might be a hybrid of mobile and console gaming. A few rumors are circulating on how this might work. Nintendo recently filed a patent for a gaming system that resembles a cloud-computing setup, where a game can be played on the mobile device and also on the console (with better graphics). The console would use the mobile device, as well as other NX consoles, to increase its processing power via the cloud. What might be the case is that the NX may be an underpowered console that would utilize the cloud to power up.
Regarding the mobile device, Nintendo also filed a patent for a mobile gaming system that uses Sharp’s free-form display technology. This technology would allow for traditional handheld controls to be placed within the touchscreen via cut-out holes on the surface of the screen. If Nintendo does use this form factor for the NX mobile device, they would effectively provide a unique combination of both the wide-screen portability of smartphones, with the gameplay-centered aspect of a handheld system. This could be something many casual gamers would buy.
Don’t believe casuals would buy a handheld in this day and age of smartphones? Sales of Nintendo’s 3DS have improved dramatically, following the price cut from $250 to $170. In fact, sales are even accelerating, according to a VP at Nintendo. From these facts, we draw the conclusion that although dedicated mobile gaming has been devalued in the age of smartphones, it doesn’t mean that it has no value. You may just have to price your device competitively.
This brings us to Macquarie’s speculation that the NX’s mobile device will be priced at $200 – only about 18% higher than the 3DS. Interestingly, Macquarie also expects the handheld to ship this year, 2016, with the console to follow in 2017.
Connecting everything would be the Nintendo account, an online account system that also includes a rewards program where you can redeem points to get exclusive Nintendo merchandise. You could gain points by buying or even just playing games (which hints at an achievement system). Additionally, Nintendo is looking at non-traditional ways for gamers to use the Account, such as gaining and redeeming points in theme parks.
Perhaps most surprisingly, Macquarie also speculates that the NX would work on… smartphones, PCs, and even rival consoles?! What?! How would that work? Maybe through the cloud computing concept we discussed?
All, some, or none of these initiatives may be realized. Filing a patent does not necessarily mean Nintendo will use those patents, and Macquarie is just speculating. That being said, this newsflow does paint a picture of where Nintendo is trying to go.
In our opinion, Nintendo may be building an ecosystem, similar to what Apple did with iOS, iTunes, and Mac OS. What makes Nintendo different from Apple, however, is that it has become, perhaps unwittingly, a media company.
Maybe Nintendo couldn’t avoid it. Millions of children grew up with their characters. That Nintendo will be more aggressive in its use of its intellectual property, or IP, is perhaps indicative that management realizes that IP will be key to driving consumers to its gaming business. And this combination – technological innovation combined with quality design and gaming that build strong IPs – is what makes Nintendo unique. Nintendo isn’t Apple. It isn’t Disney. It’s Apple and Disney combined.
Perhaps in recent years, Iwata was working for Nintendo to fully realize its potential. Is it a wonder that the recent spate of announcements involve not just gaming, but merchandising, smartphone gaming, theme parks, and, more recently announced, anime and movies?
Sadly, on 11 July of last year, Satoru Iwata unexpectedly passed away from bile duct cancer. In September, Nintendo executive and former banker Tatsumi Kimishima took the role of President. Given how influential his predecessor was on Nintendo and gaming in general, Kimishima has large shoes to fill. That being said, Digital World Research Founder P.J. McNealy believes that Kimishima will focus largely on continuing the direction Iwata set for the company for next 10-plus years. So even in death, Iwata’s influence will continue to loom large across the entire consumer tech industry in the coming years.
Will Nintendo succeed? We’ll only know in the future, but that doesn’t help our stock analysis in the present. And here we arrive at the final leg of our analysis – stock valuation. In this section, we’ll be estimating what Nintendo’s stock is worth, and whether we should buy the stock or not. Please remember, this exercise is for educational purposes only and does not constitute a recommendation to buy, hold, or sell Nintendo’s stock.
Firstly, how do we determine what a stock is worth? Let’s start with this tenet of finance: the value of an asset is the present value of its expected return. This makes sense because, as we discussed in our blog post on the discount rate, time is money, and we make tradeoffs for the most optimal use of money. Such decisions are determined with the help of discounting expected returns of an asset to their present values. The summation of the discounted expected returns gives us the stock’s intrinsic, or fair, value. This is what the stock is actually worth, based on our analysis and calculations.
This framework applies to equity valuation as well. One popular method of valuing stocks that uses discounting is the discounted cash flow model, or DCF, which discounts expected future profit and sums it all up. However, given the volatile nature of Nintendo’s earnings, we’ll be using an alternative method to DCF: relative valuation.
The idea behind relative valuation is that you can easily compare an individual stock to other stocks, using what’s known as a price multiple. Basically, a price multiple indicates how many times greater the current price of a stock is compared to some underlying datum. We will compare Nintendo’s current price multiple to companies that are similar – in this case, Apple (due to innovation in consumer electronics) and Disney (due to intellectual property), as well as Nintendo’s own historical price multiple. From there, we will determine what multiple best fits Nintendo, and then multiply it by the underlying datum, to get our fair value.
Since it is difficult to forecast Nintendo’s earnings, the datum we’ll be using for Nintendo is book value per share, or BVPS, which is shareholders’ equity per share available to the public. Therefore, the price multiple we will be focusing on is known as the price-to-book multiple.
Why would we use BVPS? It’s because shareholders’ equity often doesn’t change so much year-to-year, despite earnings volatility. This is because retained earnings is a cumulative number. So even though we need to forecast BVPS a year forward, as financial markets often discount present information and are forward looking, the variation in our forecast shouldn’t be as high as if we were to do the same exercise for earnings.
Although the price-to-book multiple doesn’t explicitly consider future cash flows, you can think of it as the “premium” a potential shareholder would pay over the accounting, or “book” value of shareholders’ equity. This premium would account for the growth of future cash flows.
Let’s take a look at the process of arriving at a fair value for a stock via the price-to-book method. Since we currently do not have the information and resources, for example, to determine how many copies of each game and game system were sold last fiscal year in order to forecast Nintendo’s revenue on a granular level, we used Nintendo’s management’s guidance for fiscal 2016 revenue.
From there we filled out the 2016 income statement, balance sheet, and statement of cash flows. Remember, all three major components of financial statements are connected, so filling out one item in one component helps fill out the two others. We’ll go into further details in future blog and vlog posts about this.
Next, we used the average sell-side forecast for revenue for fiscal 2017. You may often hear this referred to as “analyst consensus forecast”.
Our key assumptions in terms of profitability include slightly improving margins, as we believe Nintendo is capable of at least maintaining profitability at current levels. Plug revenue in, run our computations, and we get shareholders’ equity for 2017, which we divide by the current number of Nintendo shares outstanding to get BVPS, in our case Y9,676 per share.
Now that we have BVPS for fiscal 2017, we need to determine a proper multiple to apply to it. Currently, Nintendo’s multiple stands at 1.58x price to book. Apple’s is at 4.37x and Disney’s is at 3.50x. (Note: Data is based on share prices as of 27 January 2016). Therefore, on a price-to-book basis, Nintendo is cheaper than its comparables. The question is, then, what multiple should we use to determine the fair value, also known as intrinsic value, of Nintendo using Apple and Disney as benchmarks?
Looking at Nintendo’s 5-year historical price-to-book, or P/B, multiples, the stock has traded at an average of 1.41x, at a low of 0.83x, and a high of 2.58x. If we expect Nintendo to succeed over the long term with its strategy, we would choose the highest historical multiple, which is 2.58x. This premium would account for future earnings growth.
Additionally, the premium may also account for Nintendo’s IP. IP is normally accounted for in the balance sheet under intangible assets, which are assets that are not physical in nature. Currently however, Nintendo does not account for its IP in its balance sheet. But remember, assets can generate cash. Given the popularity of Nintendo’s IP, shouldn’t it be considered an asset?
If you still believe 2.58x is rather high, we add that it’s rather cheap compared to the multiples at which Apple and Disney are trading. For educational purposes, let’s go with this multiple. We multiply our BVPS by it to get our fair value for Nintendo’s stock, which is about Y24,900. Compared to sell-side analysts, we are slightly above the consensus estimate (in other words, the average of all sell-side analysts’ fair values), which is currently at Y22,900.
Y24,900 is our fair value. Our belief is, over time, Nintendo’s current share price should converge with its fair value, as the market prices in earnings growth from Nintendo successfully executing on its strategy (ideally). While you may see some sell-side analysts use a “one-year target price” for their fair values, meaning that they expect Nintendo’s share price to converge with the fair value within a year, in reality it’s very difficult to time share price movements. In our opinion, what’s more important is that the potential upside to the stock you buy has to be significantly larger than what the broader market should return, otherwise, why not just by an index ETF, for example one that tracks the S&P500?
In such a case, we need to compare total returns. Based on our analysis, Nintendo could potentially return you 58.2% on capital gains and 1.0% on dividend yield (assuming Nintendo maintains an annual dividend of Y150/share), for a total return of 59.1%, which is significantly higher than the long-term average annual return of the S&P500, which is about 11.8%. But, as we know, high reward means high risk.
Some of this seems rather arbitrary – how can multiples really capture Nintendo’s potential earnings growth? Why would we choose Apple and Disney as comparables? This is where, in our opinion, investing becomes difficult, and more of an art than a science. Despite all of our qualitative and quantitative analyses, we cannot predict the future. So we have to use our analyses and make an educated guess as to what will most likely happen. This is also why we stress diversification when you invest your assets – in case one investment doesn’t work out, ideally the performance of your other investments should offset it.
Going back to Nintendo, does it deserve our valuation? It depends on whether you believe in the ecosystem they are potentially developing. Management seems to be bullish on this – Kimishima was recently quoted as suggesting that Nintendo would reach Y100 billion in operating profit in several years, four times as much as in fiscal 2015.
Sounds like wishful thinking, but consider this. Yes, the WiiU was unsuccessful, but that was just one product. Historically, Nintendo has had more hits than misses. Maybe in the late 2000s, early 2010s, Nintendo was just at the wrong place at the wrong time. Sometimes it’s difficult, if not impossible, to beat economics; Sony and Microsoft drew in the hardcore gamers while casual gamers flocked to smart devices. Maybe, at that time, technology had not advanced far enough for Nintendo to offer something unique. For example, only in 2014 did Sharp debut its free-from display, a technology that Nintendo may make use of for the NX, whereas Nintendo had to come out with new gaming systems years earlier, just to stay relevant.
Moreover, was Nintendo wrong to slowly introduce Mario and company to smartphones? After all, Angry Birds creator Rovio’s business is shrinking, while King Digital has been seeing weaker demand for its Candy Crush game. In an interview mere months before his death, Iwata told Time magazine that “in the digital world, content has the tendency to lose value, especially on smart devices.” Given the recent weakness in Rovio and King Digital’s businesses, his words sound prescient in hindsight.
We will continue to give updates on Nintendo on both the Art and Finance vlog and our Finance Blog. For all our Youtube subscribers, please visit the “Finance Blog” section of our website for our latest blog and vlog posts on Nintendo. You can also subscribe via social media; links are in the description.
And so concludes our stock analysis workshop and case study on Nintendo. In closing, I would like to leave you with the following analysis of Nintendo and its staff, including Shigeru Miyamoto and especially Satoru Iwata. In its obituary on Iwata, the Financial Times noted that, compared to his peers, Iwata “understood one thing that his competitors did not: that magic beats technology.” Magic beats technology.
Ramon Rodrigo Cuenca, CFA
Art and Finance
CFA Curriculum Level I, 2009, volume 5, pp. 119, 125-126