Why Electronic Arts Was the Top Stock on the S&P 500 Last Week

Let's play a game.

I'm going to tell you a story, and then it's your job to identify what's wrong with it.

On May 7, this past Tuesday, video-game maker Electronic Arts (NASDAQ: EA  )  reported earnings for its fiscal fourth quarter and full year ended March 31. Its revenue for the quarter was $1.209 billion, equating to a 11.6% decline compared with the same quarter last year. And for the year, its sales came in at $3.797 billion, or 8.4% less on a year-over-year basis. On the heels of this news, shares of the company ended the week higher by 27.2%, making it the top-performing stock on the S&P 500 (SNPINDEX: ^GSPC  ) .

According to EA Executive Chairman Larry Probst: "As we enter a new fiscal year, EA is well positioned for dynamic growth on next generation consoles, PCs, and mobile platforms. With world-class games, a rapidly growing digital business, and top-notch creative talent, we are excited about EA's strategy for FY 2014 and beyond."

So, to get back to our game, what (if anything) is wrong with this?

If you think there's a disparity between its actual performance and the reaction of the market, then you're not alone. How is it possible that a company that manufactures products to sell could be rewarded in the market for recording a double-digit decline in year-over-year quarterly revenue? That's not a rhetorical question; I'm actually curious. 

To be fair, EA did report growth in its bottom line. For the 12-month time period, it earned $0.31 in diluted earnings per share compared with $0.23 the preceding year. However, and this is an important point, all of the growth came in the previous three quarters, as its fourth-quarter diluted EPS was actually less by 13.2% on a year-over-year basis. 

The catalyst for the move in its stock, in turn, clearly had nothing to do with its performance. The dramatic uptick was predicated rather on future expectations (that's a nice way of saying "hopes and dreams"). 

In the first case, the company raised its guidance for fiscal year 2014. It now expects to earn $1.20 in non-GAAP diluted EPS. That compares with an average analyst estimate of $1.08 per diluted share. And in the second case, the company announced a partnership with Disney (NYSE: DIS  ) , under which EA now has the rights to create games based on the Star Wars franchise, though -- and this, too, is a critical point -- the financial terms of the deal have not been disclosed (use your imagination about who had the negotiating leverage here).

So here's what I would say: We've learned time and again that company forecasts and analyst estimates should be taken with a grain of salt. Quite simply, neither has an incentive to tell the truth, and neither is punished for a lack of accuracy. And with respect to the Disney partnership, there very well could be something to this. But there also may not be. And if there is, as I intimated in the previous parenthetical, it's not as if EA will keep all, or even the lion's share, of the spoils. 

My point is this: After the price move, EA now trades at 41 times earnings. That's expensive. And it presupposes significant growth based on little more than castles in the air.

Looking for more insight on EA?
While Activision Blizzard and Microsoft have been taking the headlines when it comes to console gaming, investors following the gaming sector would do well to also keep tabs on Electronic Arts. We can help. The Motley Fool's special report breaks down the risks and opportunities facing the company to help you decide if EA is right for your portfolio. Click here to get your copy now.