Ubisoft Entertainment (OTCMKTS:UBSFY) finds itself in a transitional moment. French media giant Vivendi  (OTCMKTS: VIVHY) had long been trying to acquire the rest of Ubisoft. Vivendi owned 27.3% of Ubisoft stock and wanted to take over the whole enterprise. Ubisoft was supposed to become a key element of Vivendi’s multi-pronged media strategy involving pay TV, music, video games and advertising.

However, Ubisoft’s management didn’t want to sell, and it won out in the end. Vivendi ended up deciding to dump its stake, announcing that move in March. That leaves Ubisoft changing directions. What’s next for the company now that it has new backers and won’t be takeover fodder?

Here’s what it means for shareholders.

The Chinese Opportunity

A group of shareholders was willing to purchase Vivendi’s sizable stake. This group included investment banks, a Ubisoft share buyback program, the Ontario Teachers’ Pension Plan and, most notably, Tencent Holdings Ltd (OTCMKTS:TCEHY). Tencent picked up 5% of Ubisoft for 370 million euros ($431 million dollars).

For Tencent, this is a drop in the bucket, given the company has a market cap of $480 billion, making it Asia’s most valuable listed firm. That said, while the overall size of Tencent’s investment may be small, it could receive strategic focus on its end. Tencent has made no secret of its aspirations in gaming, and Ubisoft hasn’t made big inroads into the booming Chinese market yet. The pairing makes sense.

Ubisoft has traditionally been slower to make waves in the mobile gaming space compared to its American rivals. Tencent’s involvement should help Ubisoft familiarize itself with best practices in this fast-growing segment of the video gaming market.

Strong 2018 Results

Ubisoft reported excellent numbers for the annual year ending March 31 — as a French company, Ubisoft uses a different reporting calendar than many American firms. As reported in dollars, for example, annual revenues soared from $1.6 billion for fiscal year 2017 to $2.1 billion for this year.

The company was also able to push margins up a bit, allowing for a large portion of that revenue growth to turn into profit. Operating income surged from $215 million in the previous year to $321 million for 2018, making for a gain of almost 50%.

What’s going right for Ubisoft? Several initiatives are paying off. For one, its push into e-sports with the Rainbow Six series is working out nicely. It’s up to 30 million users, and viewership for the Six Invitational grew 300% this year. In new game releases, Far Cry 5 was a huge hit, earning an estimated $310 million in its first week, according to the company. That makes it the second-biggest launch in Ubisoft’s history.

The company’s transitional efforts are also paying off. Back-catalog sales continue to rise, up to 47% of total revenues this year from 44% the previous year and continuing a steady upward trend. As investors know, recurring revenue often makes for soaring stock prices. Digital revenue also pushed up to 58% of the total in 2018, a solid bump from 50% the previous year. That transition allows for Ubisoft to earn higher profit margins.

Ubisoft Stock Is Fully Valued

Ubisoft isn’t all that expensive compared to its sector. The issue is that all of the major video game stocks are exceedingly pricey. Electronic Arts (NASDAQ:EA) is arguably the only one that is defensible at 35x earnings. Even then, at 8x sales, and 9x book value, EA stock is no bargain. Take-Two Interactive Software, Inc. (NASDAQ:TTWO) sells for more than 70x earnings and similar sales and book value ratios as EA. Activision Blizzard, Inc. (NASDAQ:ATVI) goes for 60x earnings, along with 7.5x sales and 6x book value.

So, against that group of bloated valuations, Ubisoft’s own numbers seem in-line with the group. But still, they’re up there. Take a look. Ubisoft is at 78x trailing earnings, 6x sales, and fully 11x book value. These stocks are all at nosebleed valuations based on earnings, sales, and their valuation compared to their inherent assets.

Investors will argue that this is a new era for video games. And it had better be, or these valuation ratios are going to collapse. Ubisoft, measured in dollars, has grown revenues less than 5% per year compounded over the past 10 years. It did $1.4 billion in revenues in 2008, compared to $2.1 billion over the past 12 months. Sure, 2018 results look great, but what about the nine years before then? Is this sudden surge in profitability sustainable, or just a flash in the pan?

Ubisoft Stock Verdict

The higher these video game stocks go, the stronger my instinct gets to avoid them. That may make me look foolish in the short-run. As famous hedge fund investor David Einhorn put it, “We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly.”

Put another way, there’s no telling when investors will come to their senses. As long as we’re in silly season, these stocks — including Ubisoft — can continue going up. Once investors stop caring about rational valuation metrics, the sky is the limit in the short term.

But make no mistake, unless the video game industry has made a great and sustainable advancement in profitability, there’s no way that all these companies can keep up their rapid growth rates. The gaming pie isn’t expanding that fast.

At the time of this writing, the author held no positions in any of the aforementioned securities.