Valuing Tulips: Guesstimating the Future of GameStop and AMC

To guesstimate what the return would be to an investor who decides to play roulette, or in this case Russian roulette, and buys GameStop or AMC stock at today’s prices

Since tulip-mania reached a crescendo in Amsterdam in 1637, investors have been known to engage in manic behavior when opportunities for high profits (seem to) present themselves. Such was the case during the recent “meme-stock” craze, when retail investors used social media to organize a buying spree of stock in video game retailer GameStop (GME), creating a short squeeze that saw its stock price rise from $19 to over $300 over the course of the month of January. Media hype inspired new waves of buying from investors who wanted to get in on the fun, and the frenzy spread to other highly-shorted stocks such as AMC, Bed Bath and Beyond, BlackBerry, and Koss, before they all came crashing back down. And so the story ended…

Or did it? Last week, a new wave of panic buying hit meme-stocks, perhaps inspired by the introduction of a new exchange-traded fund called FOMO, short for “fear of missing out”, that gives investors access to a portfolio of the trendiest stocks (see the Tweet below from Fortune Magazine on FOMO and read my post from last week on why you should avoid thematic ETFs like this one). The main target of last week’s frenzy was the movie chain AMC, whose stock price approximately doubled from $13 to $26. #AMC500k and #AMCSqueeze started trending on Twitter, and trading in AMC made up more than 10% of all the trading on the New York Stock Exchange.

Missing out on meme stocks? New FOMO ETF lets you ride the wave https://t.co/FRF92fn3Hy

— FORTUNE (@FortuneMagazine) May 27, 2021

Now, there is pretty widespread agreement among anyone who has ever done fundamental analysis that GameStop and AMC stock are wildly overpriced, but in this post, I will try to explain why that is the case. I will also do some simple analysis of my own to guesstimate what the return would be to an investor who decides to play roulette, or in this case Russian roulette, and buys GameStop or AMC stock at today’s prices.

For AMC to be correctly valued, either its future revenues would have to be four times as high as they were before the pandemic, an extremely implausible scenario, or its price would have to drop by approximately 75%.

Are they overpriced? By how much?

The first step is to see where GameStop and AMC stand based on traditional valuation metrics. The most popular valuation ratios, such as price-to-earnings (P/E) and price-to-book (P/B), are not usable because both stocks have negative earnings while AMC has a negative book value. Instead, I use revenues, and compare valuations to other companies in the same industry using all annual observations from the past 40 years. The scatter plots below have revenues on the x-axis and the market value of equity plus book value of debt on the y-axis. (Debt is included because some fraction of the revenues is used to pay debt-holders.) All numbers are inflation-adjusted, and each dot represents one firm-year observation.

The above plot includes all movie theater chain stocks from 1980 to 2020. AMC’s current valuation, based on its May 28, 2021 stock price, stands out as the very obvious outlier at the top left of the graph. Historically, movie chain stocks with around $1.5 billion in (inflation-adjusted) revenues were valued in the neighborhood of $2 billion dollars, while AMC’s debt plus equity are currently valued at around $23 billion. Even if you assume that 2020 was an anomaly, and that the 2019 revenue of $5.5 billion is the more appropriate figure for AMC’s revenues, you would plot today’s AMC valuation as the red diamond which would still imply a valuation four times as high as the best-fit line would predict. For AMC to be correctly valued, either its future revenues would have to be four times as high as they were before the pandemic, an extremely implausible scenario, or its price would have to drop by approximately 75%.

This second plot shows stocks of all retailers of games and electronics from 1980 to 2020. Like AMC, GameStop’s valuation is well above the best-fit line that represents historical norms. Its $5 billion in (inflation-adjusted) 2020 revenues is historically associated in this industry with a valuation of $4 billion, while GameStop’s debt and equity are instead currently valued at around $16 billion, again four times higher. The closest analogue to GameStop’s current valuation is the dot closest to it, RadioShack (parent company RS Legacy) during the dot-com bubble in 1999. Although RadioShack’s revenues stayed relatively flat for the next six years, its (inflation-adjusted) valuation dropped from $15 billion in 1999 to $3.3 billion in 2005, a good yardstick for the future stock performance of GameStop.

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Expected returns based on historical analogues

Next, to estimate expected return for stockholders of GameStop and AMC, I look for all companies, in all industries, that had similar overvaluations compared to their peers (i.e., at least four times the industry average). There were 5,298 such outliers (about 2% of all firm-years) in the sample of public firms from 1980 to 2020. The table below shows the average return for these “overpriced outliers” in the following one, three, and twelve months, and how they compare to all other stocks.

Broadly speaking, stocks in this range of valuation, have average annual returns that are more than 15% lower than their peers. Extrapolating this rate, it would take five years for them to return to their industry’s normal valuation. Interestingly, this time horizon is similar to the Radio Shack experience. It’s important to emphasize that while these are averages, some of the high-fliers performed better while others did worse, historical averages are very helpful in predicting future price patterns.

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Why are they overpriced? A look at some academic studies

Since this is a blog “with an academic flavor,” I can’t help but point to the relevant academic literature which should help elucidate what is happening to these stocks and why they are so overpriced. There are three famous papers that are relevant to this discussion.

Miller (1977)

A 1977 paper in the Journal of Finance by Edward R. Miller explains that in financial markets there is often a divergence of opinion about the prospects of a particular company: some agents are optimists while others are pessimists. Another common feature is the limited ability to short sell, occurring when it is difficult and/or expensive to borrow a stock, the prerequisite for shorting, or because shorting is too risky since the stock can move in the wrong direction (UP!) and lead to losses and a margin call. When you put those two features together, you have a mechanism where the optimists can make their opinions known (by buying) while the pessimists are muzzled (because of limits on shorting) and the market price ends up too high, exactly what has unfolded in recent months with the meme-stocks.

Fama and French (1992)

A second related paper is the renowned 1992 article in the Journal of Finance by Nobel Prize-winning economist Eugene Fama and Ken French. Traditionally, expected return to investing was thought to be entirely a function of risk (specifically systematic risk or beta). If you buy a low-risk stock, you would expect to earn a low rate of return, while if you buy a high-risk stock, you would expect a high return. Fama and French argue that two other characteristics also predict average future returns: the size of the company, as measured by its market capitalization, and the “valuation” of the company, as measured by the ratio of its book value of equity to market value of equity. “Growth” firms, i.e., those whose market valuations far outstrip the book value of equity on the balance sheet, have historically been poor performers. Since the meme-stocks have very high valuations compared to their fundamentals, Fama and French’s research says we should expect them to earn lower-than-average returns in the future.

Baker and Wurgler (2007)

The third related paper by Malcolm Baker and Jeffrey Wurgler was published in 2007 in the Journal of Economic Perspectives. They use six different indicators of overall sentiment, such as trading volume, to create a sentiment index. When this index is high, investors are at their most optimistic and greediest, while when it’s low, they are pessimistic and fearful. Then, Baker and Wurgler show that stocks that are the most speculative (difficult to value) and most difficult to arbitrage are the ones that are most sensitive to their sentiment index. When aggregate sentiment goes up, these stocks become overpriced and earn low future returns, and when it’s down, they become cheap and earn high future returns. Again, it’s really easy to relate this story to GameStop and AMC, since market sentiment has been extremely high this year and these stocks are very speculative (and difficult to short), we would expect them to be overpriced and to underperform in the future.

Conclusion

To conclude, the above analysis of meme-stocks on top of the relevant academic literature leads to the inevitable conclusion that they are extremely poor long-run investments at today’s prices. While the exact horizon at which they will underperform is indeterminable, if you are considering buying them, you should realize that you would be making a much better decision to take your money to a local casino and randomly bet it on any game there. You might even get a free drink out of it.