In this article we will prove that Gravity Co. Ltd. (“The Company” or “Gravity”) is over-valued at the current trading price of $190. Considering that we do not anticipate subscription revenue or royalties and fees to increase substantially the valuation of Gravity depends almost exclusively on the growth of the mobile game revenue streams.
The process of proving future outcomes is difficult, we believe by approaching the valuation with epistemological uncertainty in mind (Tannert, 2007) and providing a structured framework a sufficient conclusion can be reached. We will provide justifications for all assumptions made — in many situations we rely on the fact that it is more likely for a company to shrink than to grow. This core belief is supported by the idea that a series of sound consecutive decisions must be made for a company to grow; and it is more likely for management to fail to make these decisions than to make them consecutively, at the right time, and in the right manner (illustrating the importance of competent management).
Understanding the locations where Gravity is operating is instrumental in understanding the current state of the company and will assist in developing reasonable forecasts for future revenue streams. At first glance, the company appears to be a titan in the industry with a large influence on its competitors, however, as you look further into its history, its not just a straight line. The company was founded in 2000 when the pc gaming industry in South Korea was in its infancy. In 2002, the company released its ground-breaking game “Ragnarok online” based on a popular graphic novel in Korea. The game was met with positive reviews and a cult following, its popularity in Korea lead to the game being successful overseas. In 2003, the company suffered a major cyberattack to its servers which lead to the eventual downfall of Ragnarok online. The nature of the cyberattack was to destroy the servers which were responsible for Ragnarok multiplayer function which was a large part of its popularity. Despite the setbacks to the company, they decided to use the popularity of Ragnarok online to create an expanded universe where each new game would have some elements that was related to its predecessor. Since 2012, the company has shifted into the mobile gaming market, focusing on the brand they have created.
We’ve approached this analysis using the discounted cash flow (DCF) method and forecasting the future cash flows for approximately fifteen years and subsequently applying a rate to maturity discounting net income to perpetuity. We are of the view that although the DCF method is not overtly sophisticated, it is accurate to the order of approximately +- 25%.
When developing our forecasts we considered the following factors:
Being that Gravity operates in South Korea and their major target market is the East Asian video game market. A concern for the gaming industry in general is the intense competition that is present in Asia. With new companies creating new innovative games and older companies expanding on successful games they created, there is no space for errors. In terms of macroeconomic risk, the gaming industry is relative uncorrelated to changes in Korea’s economic health. One could argue that a decline in any economy could drive youth consumers to playing more games. In terms of geopolitical risk, one big issue would center around the uses of the community forum. An example would be how in-game content of the popular multiplayer shooting game “Fortnite” was banned in China for being too violent.
Gravity’s approach to marketing is unexceptional and did not stand out to us. In their annual filings they describe their approach as:
[employing] a variety of traditional and online marketing programs and promotional activities, including in‑game events, in‑game marketing and offline events. Due to the close‑knit nature of the game community, we believe that word‑of‑mouth is an important medium for the promotion of our games. (20-F, 29/04/2020)
This approach is logical and targets their niche prospective users. The question of what is the most efficient method to market in the digital age, especially for niche industries was not a focus of our research.
The major gap we found with their marketing approach was in relation to their extensive campaigning in Korea (other campaigns were not mentioned in their official filings, nor on their investor relations websites). This leads us to question their expansion plans to different regions and their approach for capturing market share in said regions, as the Korean market for video-games is extensively saturated, our opinion is that any dollar spent on marketing in Korea is not being fully utilized (especially in relation to their lacklustre growth in their established games).
To forecast and develop a model of what is probable, we must understand the breakout of the video-game market which can be used to develop forecasts on market penetration. It is no mystery that the video-game industry is growing, the question is not whether it will continue growing for the next decade but at what rate with some projections already out estimating a $300bn industry by 2025 (Variety, 2019) especially considering factors such as 5G rollout, expansion of network coverage, cheaper universal data costs, cheaper/more efficient mobile devices.
Based on NewZoo’s projections the 2.7bn gamers in the market will spend $159.3bn in 2020, with the majority of the market share (~48%) being in mobile based games. NewZoo’s projection of growth for 2018-2023 is 9.4%. It should be noted that approximately half of the market share is concentrated in the Asian-Pacific geography whilst a third is concentrated in the North-Americas. The largest spender on video-games is China followed by the US.
Knowing the approximate breath and size of the market and the historical performance of Gravity’s games, and an approximate understanding of a dedicated fan-base, we approached the forecasting of mobile revenues with a conservative method drawing parallels with the growth of other video games.
We have also researched Gravity’s major competitors mainly Nexon. We are of the view that Gravity is not providing sufficient information to develop comprehensive forecasts especially in relation to the performance of their many games in service. Currently only single line items are being provided for Mobile Games and other tranches of revenue streams whilst Nexon is providing information on performance of their major games (i.e. Maplestory) in their investor relation paperwork and external communications. It should also be noted that in their financial filings Gravity mentions “material weaknesses” related to controls and tracking of deferred revenue which is highly concerning to us as it leads us to question the competency and accuracy of the figures reported in the financial reports (even if it is only for deferred revenue), as such, this inherent uncertainty has been included in our formulation of the discount rate.
The question of whether increasing our discount rate will accommodate the inherent uncertainty of the figures in our forecast is an interesting one as the magnitude of the uncertainty and variance was not disclosed in the financial statements (20-F April 29, 2020). In the event that the figures do not differ substantially our approach of increasing the discount rate based on the lack of controls decreases the value of future cash flows for no reason (thereby resulting in a more pessimistic forecast). On the other hand, in the event that the figures do differ substantially, a higher discount rate may not be drastic enough (in terms of handling the increased risk).
Our model of choice for this valuation, and most valuations was, and is discounted cash flow analysis. From our experience, the drawbacks of the simplicity of this method of analysis are easily recouped from how streamlined and modular this approach is. For our target accuracy of 25% we have found this approach to be sufficient in exposing opportunities, and the few cases where this approach of analysis is not feasible do not apply to our target companies.
The major parameters that we needed to define for this approach are a discount rate and a rate to maturity. The discount rate is self-explanatory, for determining the discount rate for our model we broke out the discount rate into components and summated them to a total model discount rate. The yield to maturity is the rate that we extend our net income forecast to perpetuity, as there is only a certain future bound that we can ‘accurately’ forecast (for us this is 10-15 years) the yield to maturity provide the missing bounds to fill in the parameters of the NPV formula. The yield to maturity rate was determined by taking into account risk factors of the company and their resilience and tenacity which we judge from this history, historical spending trends, and the companies ability to retain management and board members for larger periods of time.
| Discount Rate | 11% |
|---|---|
| Rate to Maturity | -1% |
Our breakdown of the aspects of the discount rate have been tabulated below,
| Macroeconomic (Lending rate for Corporate Debt for Gravity) | 5% |
|---|---|
| Growth Risk | 6% |
| Total Discount Rate | 11% |
4.1.1 Discount Rate: Macroeconomic Risk
The macroeconomic risks related to inflation and geopolitical pressure has been determined by taking into account South Korea’s outstanding 10 year bonds, the Bank of Koreas monetary policy planning (future and present), along with the credit rating of Gravity. We have not included consideration for the COIVD-19 pandemic factors within this category. As Gravity does not have any corporate debt outstanding at the time of writing, we have
4.1.2 Discount Rate: Growth Risk
We have categorized risk related to revenue growth, market penetration, management, and demographics has been included in this category. Revenue growth risk is in relation to the likelihood of our forecasting revenue growth to be realized based on our model. The market penetration risks are in relation to the expansion of Gravity operations in markets outside the East-Asian video game markets in Korea/Taiwan/Japan/Singapore/Etc. Demographic risk is in relation to the expansion of the video game market as the current trend is the normalization of video-games especially in non-East-Asian cultures which has been observed especially in the Americas through the development and growth of the e-sports scene for League of Legends, in order for our analysis to hold the market has to either grow or stay stable.
When forecasting the growth/decline of Gravity we approached this problem first by listing out outcomes we don’t believe will occur:
From these assumptions we can narrow down what is likely to happen, generally when we approach forecasting we have found it useful to utilize conjunctive probability to develop probability matrixes of scenarios and the respective likelihoods of those scenarios. For this particular forecast since we have the assertion that Gravity is their mobile revenue streams the scenarios are quite simple — either the mobile revenue growth grows and captures a portion of the market or it does not grow (or captures a minute share of the market). We believe that since the IP, and core user/fanbase exists for the Gravity’s products that the question is how much of the mobile market share Gravity can obtain. We’ve modelled Gravity capturing their market share through some exponential/logarithmic growth function and plateauing back to a stable growth (Gravity has proven the capacity to retain users).
Based on our model we have estimated that Gravity’s EV per share to be approximately USD$70 per share. We believe that the market is overestimating the possible growth that Gravity can obtain.
(variety, 2019) = https://variety.com/2019/gaming/news/video-games-300-billion-industry-2025-report-1203202672/
(NewZoo, 2020) = https://newzoo.com/insights/articles/newzoo-games-market-numbers-revenues-and-audience-2020-2023/
Tannert, C. (2007). The ethics of uncertainty. EMBO Reports, 892-896.