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I appreciate the power of a good growth stock. I really do.

If you can find a company that is going to grow earnings and cash flow at a rate of 20% a year for the foreseeable future you are going to do very well as an investor.

A company with high rates of growth like that allow for an investor to pay a premium valuation and still make a lot of money.

A company growing at those rates will grow into a current lofty valuation and then right through it on to better things.

Twitter (NYSE:TWTR) is a company with some fantastic growth rates. Could it be a great investment at current prices?

The short answer from me is no. I think the current Twitter valuation is stretching things just too far.

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With 545 million shares outstanding and a current stock price of $41 Twitter has an enterprise value of $22 billion.

I think that valuation is outrageous compared to Twitter's financial performance and subjects those investing at the current share price to a great deal of risk.

Here is a look at some of the numbers that come directly from the Twitter SEC filing linked above.

Valuation Relative To Revenue

Saying a company is overvalued and saying a company is of poor quality are two entirely different things. Good companies command premium valuations.

Twitter is definitely doing some great things as a company.

The top line growth over the past three years has been sensational:

2012 Full Year Revenue - $316 million (198% increase on the prior year)

2011 Full Year Revenue - $106 million (278% increase on the prior year)

2010 - Full Year Revenue - $28 million

That is awesome revenue growth year over year and it has continued into 2013.

Through the first nine months of this year Twitter has generated $422 million of revenue.

That puts the company on pace for close to $600 million of revenue for the year which would be growth of almost 100% year on year again.

That is fantastic growth. But it doesn't make me want to own the stock.

Twitter has an enterprise value of $22 billion. That means that the company is trading at $22 billion / $600 million = 36 times revenue!

The "revenue yield" at the current enterprise value is $600 million / $22 billion = 2.7%. So if 100% of revenue could be paid out this year shareholders an investor at the current price would receive a paltry return of 2.7%.

That is revenue. How about earnings?

Valuation Relative To Earnings

There is no question that Twitter is growing rapidly and has plenty of room to continue growing. The chart below shows that active users worldwide have been increasing at a rate of about $15 million per quarter for the past 18 months.

That is terrific growth, but the law of large numbers is going to catch up with Twitter as the percentage rate of growth is slowing every quarter. That is showing up in the revenue figures I looked at above as well.

If the valuation relative to revenue is bad, the picture relative to earnings likely isn't pretty either.

Here are the earnings figures for each year:

2012 Full Year Earnings - A Loss of $79.4 million

2011 Full Year Earnings - A Loss of $128.3 million

2010 - Full Year Earnings - A Loss of $67.3 million

Not a single profit has been registered in the three most recent full fiscal years. 2013 isn't going to change that trend either as Twitter has lost $134 million through the first nine months of the year.

Twitter with an enterprise value of $22 billion has yet to register a profit. That will certainly change, but I bet that would be eye opening to some investors who haven't bothered to read the company's financial filings.

Valuation Relative To Cash Flow

In the end it will be cash flow that counts. That is what pays the bills, and that is what pays dividends.

As you would expect after looking at Twitter's earnings there isn't much positive cash flow being generated by its operations.

Here are the recent numbers from the statement of cash flows for Twitter:

2012 Full Year Cash Flow - Negative $28 million

2011 Full Year Cash Flow - Negative $71 million

2010 - Full Year Cash Flow - Negative $49 million

Year to date in 2013 things are looking a little better as there is actually a positive $4 million that has been generated by operations.

However, this is cash flow from operations. We must also consider that Twitter has pretty significant capital expenditures in the prior two years of $50 million last year and $46 million this year.

This company with a $22 billion valuation does not generate any cash for shareholders at this point in time. So far all Twitter does is send cash out the door.

Now of course, this is partially intentional as Twitter is spending lots of money to grow revenues. If the company wanted to sacrifice long term growth it could cut back on spending and be more profitable and generate more cash flow today.

This Is Big Valuation Risk Relative To Potential Rewards

Not for a second am I suggesting that Twitter isn't going to turn out to be a very successful and profitable company.

I'm just saying that the valuation is extreme.

The problem that I have is that at the current valuation of $22 billion, Twitter needs to do some pretty great things for a long period of time just to justify the existing stock price.

If it has to do continue to have massive growth for many years just to justify the current valuation think of how incredible the company has to do to then justify an even higher valuation in the future?

At some point the market is going to demand earnings and cash flow from this company.

To me that means the risks here for a downward long term move in the share price are much greater than the possibilities for the share price to double, triple or more.

If I'm really interested in hitting a homerun in the tech sector I'm not going to go after a company with a big valuation like Twitter or Facebook (NASDAQ:FB). I'm going to look at small innovative companies like IZEA that is making money off of Twitter and Facebook and is growing from a small base.

It is very difficult to double or triple a stock when you are starting with a $22 billion enterprise value. It is much easier to disappoint operationally and have that premium valuation come crashing down.

At the moment there is no financial metric that supports Twitter's current valuation. These shares could drop 50% simply based on one disappointing quarter.

A Big Picture Look At Twitter's Valuation

I'd like to put this Twitter valuation into perspective.

As a very rough rule of thumb I like to think that a fair valuation for a slow growing company might be ten times earnings. For a world class company with a dominant moat (think Coca-Cola) around its business I think that a twenty multiple might be appropriate.

I think Twitter has created a platform that has a very large moat around it. I consider this to be an excellent business that will at some point be very profitable and generate a lot of cash flow.

What amount of earnings would Twitter need to have its current $22 billion valuation be a 20 multiple? Simple math tells us it would need $22 billion / 20 = $1.1 billion of earnings.

At this point Twitter doesn't even have $1.1 billion of revenue. It is going to have half that for 2013.

A better question might be how much revenue does Twitter need to justify its current market valuation?

I had a look at Google's (NASDAQ:GOOG) most recent annual filing and it shows that out of $50 billion of revenue, $10 billion drops to the bottom line as earnings.

If Twitter were to eventually achieve similar margins that would mean that it needs $5 billion in revenue in order to create the $1.1 billion of earnings that I feel would justify its current enterprise value.

That is nearly ten times the current amount of revenue that this company generates.

I don't think there is any guarantee that Twitter would ever generate that amount of revenue. If shareholders sit and hold Twitter shares waiting for those kinds of revenue numbers it there is a big chance of multiple compression.

To me buying shares of Twitter at the current price is all risk and very little chance of a satisfactory reward. I'd buy Twitter shares at the right price. And $41 per share certainly is not it.

Source: Putting Twitter's Massive Overvaluation In Perspective