On the Flaw of Price Ratios - Namco Bandai vs. Capcom

This is a valuation follow up on Namco Bandai, a stock I presented last year on this blog.

The Turnaround - Namco Bandai (JP:7832)

General remarks

The following analysis is conducted based on the stated financial parameters, e.g not adjusted for extraordinary items. The only adjustment that have been made are for operating cash flow in Namco Bandai’s case. The author deems booking Capex expenditure into operating cash flow a too blatant misrepresentation of the operational facts that has to be remidied. The accounting by Namco does not effect the free cash flow readings, but it does depress the operating cash flow readings. Although this dubious accounting procedure has diminished in magnitude over time, with 3’500 Mios.of Yen it still depressed the stated OCF readings by roughly 10% for FY 2012.

To come to a more precise picture of Namco’s and Capcom's past and current operational performance I recommend to the interested reader to do the tideous work of adjusting the stated numbers for extraordinary items!

On the deficiency of "standard" price measures

After a doubling of the stock since I have presented this holding of mine on this blog in 2012, the stated ratios don’t seem too compelling anymore at first glance. An actual P/E ratio of 14 and P/ OCF of 13 wouldn’t be regarded as a bargain issue for a value investor. Having said that, Namco doesn't appear to be too expensive neither, given such a high quality franchise. It appears just to be another wonderful company reasonably priced.

But more importantly, the standard ratios don't give away the "true" state of a companie's marketvaluation and operational performance to the  interested value investor. In many instances P/ OCF and P/E overstate or understates the valuation and operational performance of a company by a wide margin. Although widely followed and eagerly marketed by the financial community and financial media (especially the P/E Ratio), they do not deserve this close attention.

Especially the P/E ratio is a very flawed one. In contrast to the P/OCF ratio, which is mainly distorted through the numerator (P), the P/E ratio can be so by the numerator and denominator. The distortion of the numerator mainly comes into play when not taking into account differences in the capital structure of a company, e.g. debt vs.equity financing on the passive side of the balance sheet and different asset composition on the active side of the balance sheet.

The distortions on the denominator mainly happens through different accounting policies applied by companies and secondarily through differences in the financing of a company (debt vs. equity financing).

Making the case for EV, Ebit and Ebitda

The concept of enterprise value (EV), earning before interest and taxes (Ebit) and earning before interest, taxes, depreciation and amortisation (Ebitda) adjusts for those flaws found in pure price metrics.

In the case for EV the market capitalisation is adjusted for the interest bearing debt on the balance sheet (e.g. added to the marketcap) and the companie’s cash balance (e.g. substracted from the marketcap). Basically, it is the money an potential buyer has to put up for acquiring the whole company free of interest bearing debt.

Ebit is a more conservative adjustment to net income, as it only adjusts for different financing and tax regimes and tax deduction possibilities. The concept of Ebit is closer to the accounting earnings of a company.

The concept of Ebitda goes much further. Net income is not only adjusted for interest payments and taxes paid, but also for depreciation and amortisation. Ebitda is closer to an operating cash flow metric than to an earning metric and thus should be used cautiosly as a proxy for earnings!

Those metrics and the derived ratios (e.g. EV/ Ebit; EV/ Ebitda instead of P/E) are much more meaningful for gauging the “real” cash generating-/ earning power and valuation of a company than the standard metrics. Furthermore, it enables the analyst to compare companies in the same business field with different financial leverage and asset composition. Using those metrics instead of price metrics is the “adjustment for the lazy analyst”. Easily done, straight forward and it gets you closer to the "true" fundamentals rather quickly. But more digging into the annual reports is still warranted.

"Adjusted" valuation metrics in the case of Namco Bandai

In the case of Namco Bandai those "adjustments" have got quite a significant impact compared to the "stated" readings. Instead of a great company at a reasonable price, one apparently (still) gets a great company at a very good (e.g. cheap) price.

Especially when taking into account qualitative issues. Among other highly profitable IP's Namco owns, Gundam has been and still is highly popular in Japan. And I doubt that the Gundam franchise is going to cease being a huge cash cow tomorrow. Furthermore, Namco has a very good corporate governance framework (small board with 3 members being outside directors).

In Namco Bandai's case an higher share price neither has to come from an expansion of its earning multiplier. They would just have to cease their painfully conservative accounting policy. 

Namco Bandai vs. Capcom

Namco Bandai has outperformed Capcom by a huge margin. This is noteworthy, especially when having in mind the fact that both companies saw dramatic changes in their business envrionment coming (among others the trend to casual gaming). As well Namco as Capcom shifted their business strategy toward and IP axis strategy, which allows to better utilise their IP's in this rapidly changing business environment. So it is not that Capcom has missed out on something here.

I see two reasons to stand out for Namco Bandai's dramatic outperformance.

1.) Valuation in the case of Namco Bandai was and is significantly more compelling. It wasn't and isn't so obvious using the price ratios, but rather when one uses EV/ Ebit, EV/ Ebitda, etc.

2.) Namco Bandai seems to have fared much better in the past operationally. Furthermore, it seems that Namco executed way better on the new business strategy and capitalised on that strategic shift than did Capcom. This becomes quite apparent when one analysis both companies past operational performance. Especially when digging into their respective financial statements and adjust the stated numbers for all the extraordinary items (and they weren't too few in both cases!)

3.) I personally think that Namco Bandai has got the stronger franchise. But this is a bold call and I wouldn't bet too much on this last assumption!

And the moral of this little value story is ...

... that people mainly concentrating on P/E ratios when searching for undervalued markets and/ or securities are very likely to miss out on very interesting opportunities. Especially in the case of Japan! Discarding this major financial market on the basis of high P/E multiples are missing the whole point on this investment case for quite obvious reasons.


Disclosure: Long Namco Bandai