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The problem with many stocks like Facebook (NASDAQ:FB) is not their business model, or management's competence or even the quality of their earnings. The main problem for market participants, in the age of QE to infinity, is that things are not what they once were and it confuses investors.

The confusing thing about today's market, is that many times you don't know if you should be buying or selling. Because many stocks today are at bubble like valuations (compared to yesteryear), it's very hard to tell if the market has discounted a good earnings announcement or not.

Facebook's Third Quarter results were better than what the market expected and the stock soared up as much as 15% in after-hours trading, only to lose everything by the time Facebook's conference call was over.

Let's look at the price action from the after-hours session right after Facebook's Q3 announcement (after-hours session in yellow).


(Click to enlarge)

Facebook opened up in after-hours trading at $58 a share on the "good earnings announcement", only to lose everything in the following two hours and then some, before closing flat for the end of the day.

The question is, why did investors behave so irrational? My take is that most people don't even bother to look at the valuation of the stock and simply buy (or sell) with a herd like mentality and a trading pattern to match.

On the other hand, the smart money -- the money that knows how to count and measure valuations, and knows how to exploit herd mentality -- simply sold everything they could in those few hours of trading, knowing that even if Facebook's results were good, they were more than baked in the cake and then some.

As things stand today, Facebook's market cap is $122 billion, with total sales over the last 12 months reaching $6.8 billion and after tax profits about $1 billion. Despite the high growth exhibited by Facebook, this stock is too rich for many investment pallets. Granted that profits are expected to more double over the next twelve months, but that still means that by this time next year, Facebook will have a P/E of close to 50.

Facebook is not a cheap stock. While profits are sure to increase in the future, a $120 billion market cap is not exactly cheap for a stock that will probably pull in $10 billion in revenue for 2014 and maybe make $2-3 billion in profits. Sure $2-3 billion is a lot of money, but so is the $120 billion market cap of the company that has to be supported by those profits.

If you want my 2 cents, the volatility of Facebook's stock in the after-hours trading session two days ago has to do with the tug of war between those who see Facebook as a bubble and those who don't.

Irrespective of who wins the battle, it is important to note that Facebook's valuation is not for the average investor. Yes it can continue to go up, but keep in mind that the market has already discounted a big portion of the company's future growth, and any deviation from market expectations might bring the stock down by a lot.

Bottom line

Most of my recommendations are geared towards long-term investors who are not day traders or hedge fund managers. As such, I cannot recommend Facebook as a core holding in any long-term minded portfolio. The valuation of the company is simply too high and the risks outweigh the potential reward for future profits.

Source: Facebook's Results Were Good, But Its Valuation Is Scary