Why Zynga Inc (ZNGA) is Overvalued with or without Online Poker

Let’s be frank: Zynga Inc (NASDAQ:ZNGA)‘s current batch of online gaming properties doesn’t justify the company’s current market cap. Zynga’s gaming franchises are fun and even addicting (who hasn’t played too much Words With Friends?) but from an investment standpoint they simply aren’t compelling.

So that leaves us with the enterprise as it exists plus the Zynga Inc (NASDAQ:ZNGA) Poker option. The company has net-net working capital of $750 million, implying that the actual value of the continuing operations and poker potential is worth $2 billion.

Does Zynga have a $2 billion opportunity in poker?

The company’s big Zynga Poker franchise is the largest free-to-play poker game in the world with 38 million active users, but the app itself isn’t a blockbuster, seeing as players use fake money to place their wagers.

Ascribing value to Zynga Poker isn’t easy. It’s best comparable is the old PokerStars, which did $1.4 billion in revenue and $500 million in net profit from 20 million players, or $25 in net profit per year per player. Zynga Poker has nearly twice as many members (38 million) as PokerStars, but not every free Zynga player will turn into a real money player.

I’m not one to shy away from back of the envelope math to determine a company’s intrinsic value. I assume that PokerStars included ongoing marketing in sales, general and admin expenses, which reduced its net margin. Zynga Poker, having already established itself, should have much smaller SG&A expenses, so its profits per user will likely look much like PokerStars’ revenues per user of $70.

Here’s how I look at it

A 1% conversion rate from fake money to real money at the same per-user revenue as Poker Stars would generate $26.6 million in annual revenue. Thus, a 5% conversion rate would generate $133 million in annual revenue to Zynga, while a 10% conversion would result in $266 million in revenue to the company.

These figures are hardly worth getting excited about. Assuming even an extreme best case scenario where net margin is 100% from online poker revenue, Zynga looks tremendously overvalued. The “best case” is that Zynga Poker launches today, and generates $266 million in perpetuity, which, when discounted at a 10% discount rate, is only worth $2.6 billion, implying that Zynga is only modestly undervalued with extremely rosy assumptions.

Being only slightly more realistic about the launch time – not the profitability of each user – and assuming that Zynga Poker is still 5 years away from coming online in any meaningful form, poker as an option is worth only $1.6 billion when the cash flows are discounted for another 5 years of waiting time at the same 10% discount rate.