2 Gaming Stocks to Buy Today, 2 to Consider

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The unthinkable has happened: after suffering a -73.7% drop in price over the past year, shares of Zynga (NASDAQ: ZNGA) are finally reasonably priced! This is great news for investors who wish to invest in the gaming market and social media.

In today’s market investors have other compelling game stocks to choose from. These stocks will be compared to Zynga as potential investments.

Social Networking Bubble Deflating

Thankfully the web 2.0 bubble is deflating. Facebook’s (NASDAQ: FB) IPO was a flop. Zynga, which makes games for the Facebook platform, has seen a dramatic price decline. At present Zynga looks like a decent speculative bet at this point, though this was not always the case.

Until recently, the markets were caught up in the story of web 2.0 as a megatrend.  In The next wave of digital growth is here Todd Harrison wrote that web portal usage is down 24% while social has grown 52%. He cited these changes to demonstrate how the economy of the net is fundamentally changing. New developments in the “hypernet” threaten to undercut television and web search.

Though these changes and threats are substantial, investors should wait for web 2.0 ventures to demonstrate reliable earnings and trade at attractive valuations before riding “the next wave.”

Technological Progress May not Spell Investment Returns

Equity investors must pay attention to how much they are paying for a stock. Valuation matters regardless of how often pundits say that growth will justify any price.

Unfortunately, many of these firms run losses as they ramp up, and so price-to-earnings ratios are less useful. Price-to-book ratios are also difficult to use for comparison because internal research and development is not capitalized, which may understate the accounting value of assets and equity. However, very low price-to-book ratios can be used to gauge that a company is cheap since they are gross underestimations for these firms.

For technology stocks the price-to-sales ratio is paramount since it allows some form of comparison between companies which might have off-balance sheet assets or are currently running losses. An eye for actual earnings is also appropriate, since the promise is that these companies will one day earn a return for investors.

Zynga shares did not generate profits over the last year, so it does not have a calculable price-to-earnings multiple. Now that it trades near $2.50 per share the stock has a 1.48 price-to-sales ratio and a 1.01 price-to-book multiple. This price-to-book multiple is much cheaper than the 2.05 S&P 500 average. Investors should consider this number understated because the price-to-book ratio fails to account for internally-developed intellectual property including patents, brands, and trademarks. If the economic value of these assets were even partially recorded the price-to-book value of the stock would be much lower.

Zynga is much cheaper than its social media peers which, as a group, are overpriced. Consider Facebook which currently trades at $21 per share. Equity in this this company is rich on a price-to-sales basis since shares trade at a 10.35 multiple, eight times the 1.29 the S&P 500  average and ten times the price multiple of Zynga. Facebook shares are trading at an indefensibly high 116.17 price-to-earnings ratio.

Zynga is not that cheap when compared to other game developers. Electronic Arts (NASDAQ: EA) stock trades around $13 per share. At a value of 1.01, this stock trades at a fraction of the S&P price-to-sales average multiple. EA shares are trading at a high 68.16 price-to-earnings ratio. The price-to-book multiple of this stock is 1.61, cheaper than the 2.05 S&P 500 average. As was the case with Activision Blizzard (NASDAQ: ATVI), the price-to-book ratio is low even without accounting for internally-developed intellectual property including patents, brands, and trademarks. Overall, Electronic Arts shares are a better value than Zynga shares based on established long-term profitability and attractive valuations.

Shares of Konami (NYSE: KNM) are also valued more conservatively at prices near $23 per share. At a value of 0.95, this stock trades at a fraction of the S&P price-to-sales average multiple. Konami shares are trading at an attractive 10.56 price-to-earnings ratio, lower than the 14.1 average of the S&P 500 index. The price-to-book multiple of this stock is 1.14, cheaper than the 2.05 S&P 500 average even without internally-developed intellectual property. These compelling valuations make Konami shares more compelling than Electronic Arts or Zynga shares.

On the other hand, Zynga is cheaper than Activision Blizzard at prices near $11 per share. Investors can buy more revenues per dollar from the S&P 500 or from Zynga since Activision Blizzard trades at a much higher 2.85 price-to-sales ratio. Activision Blizzard shares are trading at a fair 15.92 price-to-earnings ratio, in line with the S&P 500 average. The price-to-book multiple of this stock is 1.19, cheaper than the 2.05 S&P 500 average, but not as cheap as Zynga.

The Future was Yesterday

Proponents of the social media revolution see change and suggest that the future is now. Wise investors would have to disagree: the prospects for their investment losses are eerily similar to those from investing in the tech bubble.  Having learned from  the web 1.0 bubble at the turn of the millennium, it seems clear that the future could play out like the past. During that era, web 1.0 companies sold at prices which had not connection to reasonable valuation. In hindsight it was clear that investors were making a huge mistake by buying into that bubble. Investors wise enough to learn from yesterday’s losses will not make the same mistake with social media stocks.

Investors dead-set on buying social media stocks should consider Zynga as their least-worst option. It is trading at valuations that are appropriate, but not compelling, for a firm with no earnings. Investors who are willing to consider console gaming stocks can find deeper discounts in Konami and Electronic Arts.

Dive In, Investors

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StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Activision Blizzard and Facebook and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Activision Blizzard and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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