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GAM£S INV£STOR: The Stock Market: A Primer
July 1999
What do the following companies all have in common: EA, Eidos, Acclaim, GT Interactive, and Infogrames. Yes, they
are all games companies but they are also all listed on various of the world's stock exchanges. In fact almost every major Western publisher's shares are tradable on some public exchange and many developers have
taken the plunge too. And yet despite the apparent desire for large games companies to float on at least one of these exchanges, the City remains both poorly understood and often misrepresented by industry (funnily
enough an accusation frequently levelled at the City in its dealings with the games industry). The purpose of this article is to give a simplified overview of how stock exchanges and share trading works.
Shares and valuation
Shares are the currency of company ownership whether the company is privately held or listed on the stock market. At
its inception, a company issues shares to its shareholders at a intitial value per share. As the company grows and its value increases, these shares may gain the potential to be sold for considerably more than that
initial value. How much more depends on a range of factors -see later- but the value of a company is simply the price of the shares multiplied by the number of shares issued. Whilst a company remains privately held
(most often found in the form of a Limited company), these shares are not easily transferable and tricky to price.
Buyers and sellers of private company shares (where for example a publisher buys a privately held developer) would have to conduct their own valuation process, agree on a price/share and wade through whatever legal arrangement are tied in to the share sale. Even for small company acquisitions and investments, this process can take months. The stock market simplifies this process by giving people a medium through which they can buy and sell shares and in doing so they place the valuation process in the hands of the "market". OK now, pay attention here is the science bit:
When you buy or sell shares, more often than not, you will phone a stockbroker who passes on your order to a market
maker. Market makers are required to offer separate buy and sell (known as bid and offer) prices and accept bids and offers for all the shares in which they deal. Share prices printed in the papers are generally the
mid-prices (the average of buy and sell prices) and it is these prices that determine the value (known as market capitalisation) of a company.
The role of the market maker is becoming increasingly automated although UK games shares are still the preserve of human operators.
So why do shares go up and down? Well ultimately it is because market makers move their bid and offer prices, and, in theory, the extent of the movement is determined by traditional demand and supply economics. If there is significant demand for a certain company's shares but there is not an adequate amount of shares for sale to match that demand, then the market maker puts up his bid price to tempt existing shareholders to sell. This works the other way too; if the sellers exceed the buyers, then the share price is lowered to tempt investors to buy the shares. However, in practice, market makers often move their bid/offer prices for other reasons, more often in anticipation of surges in demand or supply (for eg before a results announcement or other developments).
So what determines the value of a company? Buyers and sellers (who, together with market makers form "the market") through their demand and supply of a company's shares determine the value of a company: they decide when a share price is too high (ie they won't buy any more or will sell) or is too low (ie they try to buy shares). Traditionally, this decision is based on research. A company's earnings power and growth potential is often compared to like companies but other factors such as dividend (profits that are returned to the shareholders) level and historic share price growth are also taken into account.
So what are these P/E's that people go on about? P/E stands for share Price divided by Earnings per share
(or EPS: a company's profits divided by its total number of shares). P/E ratios may be calculated based on last year's profits ("historic P/E") or an estimate of future years' profit ("prospective
P/E"). P/E ratios are used to compare like companies (eg games publishers) to one another and to show the extent to which one company may be under or overvalued compared to other companies.
In the UK, the average prospective P/E of games publishers is around 15. Thus where, for example, a company with a share price
of 100p is set to report profits of 10p/share it is on a P/E of 10 (100/10). Because the average is around 15, one could say that the company is undervalued and the share price should be closer to 150p (to match its
peers' P/E) and thus the share price should be 50% higher. If the company was listed in France, where the average P/E is 30, then one could argue that the company's share should be priced at 300p.
Of course there are numerous factors that might prevent that share price rising: there may not be enough investor money
interested in that company, investors may not have confidence in future profitability or there may be a large seller who for some reason is soaking up the demand for shares. For that reason it is impossible to
predict exactly where a share price will move to only where it could and arguably should move to.
Research forms the basis of good investment and one advantage that people working in the games industry have is that they tend
to understand games companies' businesses far better than those outside the industry. They should be more able to forecast not only individual title success but also industry-wide trends and thus identify when a
listed games company is under or overvalued. With many games companies' share prices having easily outperformed the main indices over the last few years, a better understanding of the City might benefit you in more
ways than one.
Nick Gibson is games analyst at research-led investment firm, Durlacher and author of the Games Investor web site
(www.gamesinvestor.co.uk).
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