Over the past decade, many analysts have touted the strength of Chinese Internet stocks, one of the fastest growing sectors in the world’s second largest economy. However, I think a lot of investors are overlooking an important market in China - online gaming. This market is a young one with plenty of growth potential, growing 35.1% year-on-year in 2012.

Thus I present my undervalued growth stock of the day - Changyou.com Limited(ADR) (NASDAQ:CYOU), a rapidly growing online game developer in the People’s Republic of China.

Fundamentals First

I first stumbled upon Changyou in a stock screener search for undervalued growth stocks. These were the criteria I originally set.

1). Market Cap: Over $1 Billion

2). P/E Ratio: Under 25

3). Gross Margin: Over 15%

4). 5-Year Revenue Growth: Over 25%

5). 5-Year EPS Growth: Over 25%

6). 5-Year ROI: Over 25%

7). 5-Year ROE: Over 25%

In the entire U.S. market, only four stocks fit all seven criteria - Apple Inc. (NASDAQ:AAPL), Baidu.com, Inc. (ADR) (NASDAQ:BIDU), Deckers Outdoor Corp (NASDAQ:DECK) and Changyou.com. However, Changyou’s fundamentals caught my attention above all else - it was the best value in all seven categories.

Changyou’s Fundamentals (as of 1/25/2012): (Source: Google Finance)

What is Changyou?

Changyou was originally the game-producing business segment of online search portal Sohu.com Inc. (NASDAQ:SOHU), but was spun off in 2007. The company went public in 2009 as a U.S.-listed ADR. Its flagship properties include Tian Long Ba Bu, Duke of Mountain Deer, Blade Hero, DDTank and other popular titles. The company has a workforce of approximately 3,300 based in Beijing.

The company has also started licensing Western games, such as Electronic Arts Inc. (NASDAQ:EA) ’Battlefield Online, which began beta tests last November.

Macro Factors

According to Chinese site Techweb, the Chinese gaming industry grew 35.1% to $9.1 billion last year. Niko Partners, which specializes in researching the Asian video game market, originally forecast the market to hit $9.2 billion by 2014. They missed the mark by a year and $100 million. Revised estimates from various firms forecast the Chinese video game market to grow annually at 12.4%, potentially reaching $21.7 billion by 2017.

To put this into perspective, the market was only worth $200 million a decade ago.

The entire Chinese video game market is PC-based, since video consoles - such as the XBOX 360, Playstation 3 and Wii - have been banned in the mainland since 2000. "The government thought that was the best way to protect Chinese youth from wasting their minds on video games, after a parental outcry," explained Niko Partners researcher Lisa Hanson.

But since it would be impossible to completely ban personal computers, PC-based games have taken off. Online PC games in China have been gaining momentum ever since 2001, when the market first reached $100 million.

Micro Factors

In 2005, several of China’s government agencies addressed the perceived threat of Internet game addiction. It introduced a “Fatigue System”, which limited the experience points gamers could earn in a single day in certain games. While game companies were required to abide by these rules, they easily bypassed these restrictions, offering “1.5x Experience Cards” which allowed users to continue gaining experience points after their daily limits were reached.