Activision Blizzard stock: Video games can be too exciting

Q: What is your opinion on Activision Blizzard stock (ATVI)?

A: The idea of investing in Activision Blizzard probably popped into your head while flipping through your video-game collection.

Activision Blizzard publishes some of the most popular video games, including Guitar Hero and Tony Hawk and the acclaimed Call of Duty series. The company's Modern Warfare 2 war simulation, due out this year, is one of the most anticipated titles in years. It's a follow-up to Call of Duty 4: Modern Warfare.

ACTIVISION: The website
BLIZZARD: The website

Meanwhile, the company controls a number of online games, including Warcraft. Online games are attractive for video game publishers because users pay recurring fees to play and are extremely loyal. If you're interested in following video-game trends, you should check out USATODAY.com's video-game community, Game Hunters at gamehunters.usatoday.com.
FIND MORE STORIES IN: Activision | Activision Blizzard | Electronic Arts

Activision Blizzard management, led by industry vet Bobby Kotick, has shown it understands the ups and downs of the business. Activision during the current economic downturn has been the most steady of the major video-game publishers. Its market value of about $15 billion exceeds that of rival Electronic Arts (ERTS) at about $6.8 billion.

But does all this mean Activision is a good play for investors? To find out, I put the stock through the four tests considered at Ask Matt:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Activision's trading history back to 1993, we see the company generated an average annual compound rate of price appreciation of 31%. This is an extremely high return; the S&P 500 posted a 6.6% annual return in the same time frame, says IFA.com.

But here's the rub: If you owned Activision, you accepted higher risk — standard deviation — of 61 percentage points. That's much higher than the 15.1 percentage point risk of the S&P 500 during the period. So to get a 370% higher return you accepted 307% higher risk. But the risk-return is almost in balance.

Based on this measure, Activision is one of the few stocks to pass this test. While Activision is much riskier than the market, its incredible return justifies the extra risk.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When I run Activision's stock, I find it's rated "dangerous." In other words, the stock is expensive relative to the cash the company is expected to generate over its lifetime.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can normally help. But due to the recent merger of Activision and Blizzard, the software giant does not have reliable long-term historical information for this analysis.

Step 4: Check the company's financial health. Before investing in a company, you want to make sure it's in good financial shape. A quick way to check is to look at where it falls on the USA TODAY Stock Meter, which ranks stocks from conservative (1) to aggressive (5). Activision scores an aggressive 4.0 here. You can get a Stock Meter score for almost any stock by going to money.usatoday.com and putting the stock's ticker symbol or name into the Get a Quote box.

Bottom line: Just as Activision's games are for thrill seekers, the stock is, too. Investing in Activision shares will be filled with excitement, fear and suspense. It's definitely not a stock for someone looking for a slow-and-steady investment. Video games are a hit-driven business, and having a hot title one year can mean huge profits. Similarly, if the pipeline of hit games dries up, a video-game stock can suffer quickly.

As the current downturn shows, Activision's management knows better than anyone how to navigate the industry's vagaries. But as an investor, you need to be fully aware of the risk you're taking when buying Activision stock.

- Matt Kranz, financial markets reporter at USA TODAY