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Summary

  • When is a great company not a great stock to own? Naturally, you always want to own companies with great management, growth at the company and industry level, etc.
  • However, there comes a point where the company’s prospects – however great they may be – are far exceeded by the expectations of stockholders.
  • If real estate’s mantra is “location, location, location,” then should Zillow Inc.’s be “overvalued, overvalued, overvalued?”.

By Steven Carroll

Seattle-based Zillow (NASDAQ:Z) is an online real estate database that was founded in 2005 and it's been doing all the right things - surging revenue, booming stock price, lofty expectations.

Puzzling model results

However, when we look at the StarMine models, we see an obvious disparity between the shorter term signals such as price momentum and analyst revisions, and the longer term valuation factors.

Check out the bearish insider model (company insiders are net sellers) and the short interest model (the hedge fund crowd sniffs an opportunity). We also see a low EQ score (the degree to which current earnings are backed by strong free cash flow, conservative accruals/exclusions).

One interesting point highlighted by the StarMine EQ model is that exclusions (i.e. pro forma earnings, rather than GAAP earnings) allowed the company to make its earnings target. On a U.S. GAAP basis, the company would have actually missed. While there's significant discretion awarded to companies in how they treat various accounting items, you can see that there's a persistent pattern of using other exclusions.

Caution flags

While price and analyst revisions momentum remains strong, one early warning sign comes from analyst recommendations. Earnings per share have surged dramatically in recent months, along with the rest of the income statement. However, analysts seem to be sounding a more cautious note - with a number of downgrades (to hold). Essentially, the message seems to be that the analysts love the stock (everyone loves fast growing stocks) but can't get themselves enthusiastic about the current stock price.

Remember Cisco?

To my original point - everyone loved Cisco Systems Inc. (NASDAQ:CSCO) in 1999. The thesis on which the stock was adored was that the world was changing - switches, routers, etc. were going to be the backbone of this new world - and who wouldn't want to buy the firm that was providing the key infrastructure? This was the modern day version of being the guy selling spades and shovels to the gold miners. It was the sure thing while the miners hoped to strike it rich.

Where's the beef?

As it happens, the CSCO bulls were entirely right on their thesis. The company did grow, did provide the backbone for today's Internet and, to boot, was, and is, well managed. Unfortunately, expectations for how that growth would translate into astronomical earnings were a little wider of the mark - the CSCO share price of 2001 remains its high water mark, despite 2013 revenue of $48.6 billion compared to $18.9 billion in 2000. Putting it another way - the market was paying $75 for $18.9 billion of revenue; today it's paying $25 for $48.6 billion.

Returning to Zillow - the company is growing revenue (EPS, not so much) at a fast pace. Management seems astute and has a great track record with Internet retail. None of that is in dispute. The question is simply whether a shareholder today, owning equity at $134 - is adequately rewarded for risk in an uncertain world. That valuation implies five-year EPS growth, compounding, of 86.7%., i.e. 86% growth every year. The forward P/E (I know earnings are out of fashion and all, but I still want to point it out) is 226 times.

Alan Greenspan called his irrational exuberance about three years too early - and wise economists always give a prediction, or a date, never both. However I think that it is clear that a number of stocks are returning to valuation zones that effectively ignore the risk of external shocks, and certainly ignore the likelihood of strong competition emerging.

In such an environment - whether retail investor or professional portfolio manager - it pays to think about the risks in the event of a misstep (look at recent performance for online UK retailer ASOS, which we covered earlier in the year). If the markets turn nervous and do some type of March 2000 replay (or 2008) - well, in such an environment you want companies with solid earnings, great cash flow and conservative accounting and exclusions policies. I think it's clear Zillow would struggle to meet that description.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Alpha Now at Thomson Reuters is a team of expert analysts that are constantly looking at the financial landscape in order to keep you up to date on the latest movements. This article was written by Steven Carroll, independent commentator and analyst. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.