After reaching a high of $141 in November, Roblox's (RBLX -0.74%) share prices now hover around $63. Should you buy the dip, or take a pass?
The company has seen a sharp acceleration in new users during the pandemic. Most importantly, those users are sticking around, spending virtual currency on new content, which is causing Roblox's revenue and free cash flow to climb.
Here's why I believe the stock is a buy at these levels.
Image source: Getty Images.
Why Roblox is undervalued
Roblox is not a flash-in-the-pan business. Revenue has grown incrementally each quarter since the beginning of 2019. Most importantly, it is free-cash-flow positive. On a trailing-12-month basis through the third quarter, Roblox generated $599 million of free cash flow (FCF) on $1.7 billion in revenue.
The growth in free cash flow makes the stock much more attractive after its recent decline. Investors can now buy shares at a price-to-FCF ratio of 54. One way to value a stock is to take the reverse of that ratio -- or the free cash flow yield -- and compare that yield to the rate offered by a long-term government bond, which is the closest thing to a risk-free return that is available.
Roblox's free cash flow yield is 1.9%. If Roblox doubled its free cash flow, investors would have a free cash flow yield of 3.8% on their investment. That growing yield is attractive against the current 10-year U.S. treasury bond rate of 1.75%.
Considering how fast Roblox is growing, a double in free cash flow may be conservative. The company reported a 102% year-over-year increase in revenue in the quarter. Also, daily active users reached 47.3 million, or more than double the 18.4 million users in the same quarter two years ago. But that player base could easily grow to 100 million and beyond.
Why Roblox could multiply its daily active user count
The company's mission is to "build a human co-experience platform that enables billions of users to come together to play, learn, communicate, explore, and expand their friendships."
There are a few opportunities for Roblox to reach the masses, including hosting more virtual concerts and other non-gaming events that drive up engagement and hours spent on the platform. For example, music artist Lil Nas X hosted a live event during the pandemic that drew a reported 33 million views. But I believe there are plenty of growth opportunities just in gaming.
Top game makers like Activision Blizzard and Electronic Arts have over 300 million players in their games. One advantage that will allow Roblox to catch up to these top gaming companies is the network effect. As more users join Roblox, more of their friends will want to join, too, so they can all play together.
Roblox is already ranked as one of the top entertainment platforms for audiences under the age of 18. This means Roblox doesn't have to spend huge sums on marketing to grow its business. That leaves more resources to invest in technology and rewarding the millions of developers that make games for the platform.
Roblox has a great business model. It generates revenue from users buying virtual currency (Robux) to unlock premium content. The company then spends around half of its revenue between developer payouts and research and development. This incentivizes Roblox users to make content, which keeps revenue and free cash flow growing.
Investors don't have to buy into the hype of the metaverse to justify buying this stock. Roblox is a buy at these levels just on its opportunities as a top entertainment platform.
