Just because someone is willing to spend a million dollars on a $500,000 color diamond doesn't mean that the diamond is bad or that the quality of the mining company who found it is poor, it just means that the buyer is wearing rose colored lenses. Investors usually spend their time analyzing industry trends and management decisions while avoiding the topic of valuation. Items like price to earnings, price to cash flows, and price to book value seldom matter very much to the modern day stock market investor. Instinctively, most people simply want to own the best business models regardless of price.
With that said, ignoring the valuation of a company makes for some nasty outcomes during bear markets. Netflix (NFLX), Opentable (OPEN), and Travelzoo (TZOO) are three examples of what happens when the love affair with "growth at any cost" investing finally ends. Here are five stocks with valuations that don't make any sense to us and why you should consider selling them or shorting them at current levels.
LinkedIn (LNKD) -- LinkedIn is one of the best business models and social media platforms around because a majority of the users on LinkedIn are the financial decision makers on the corporate level for their businesses and organizations. Like Seeking Alpha, the user base of LinkedIn is highly sophisticated and financial decision makers are the best target market for advertising spend. LinkedIn the stock, however, is another story altogether as the valuation for these shares is beyond nosebleed levels at over 550X earnings; LinkedIn shares are stretched. Also, it appears to me that another bear market is coming for equities, given the terminal cancer of the European economies which has spread because of too much debt and leverage in the global financial system. When things get ugly, the high-flying, high-valuation momentum stocks like these usually get whacked the hardest on the way down. That said, LinkedIn is probably the best social media networking site in the world for business owners to utilize for marketing their goods and services.
Pandora (P) -- Like LinkedIn, Pandora shares are equally overvalued and the stock is quite risky in our view given the current state of the economy and the high price to sales, earnings, cash flow, and book value of the name. Pandora stock is trading for an astounding 24X book value, and 12X sales. The good news for stockholders is that Pandora's listeners have more than doubled their listening hours over the past year from 1.5 billion hours to 3.4 billion hours over the first six months of the year. Pandora tracks listening hours,
because it is a key indicator of the growth or our business and the number of active users as an additional indicator of the breadth of audience we reach at a given time, which is particularly important to potential advertisers.
The company clearly offers people what they want -- free stuff. However, growth in listening hours was not accompanied in correlation to growth in active users, as active users "only" rose from 29 million at the end of 2010 to 37 million as of July 31st 2011. In other words, the growth in active users has been lower than the growth in revenues and also in listening hours. Pandora's revenues grew at an incredible 126% over the past year. Obviously, no one has a crystal ball when it comes to predicting any company's long term growth rate, however the business must grow revenues at an above 50% per annum clip to justify the current market cap in my view and must also find a way to make those sales profitable on the bottom line. After all, in business it's not what you make but what you keep that matters. Overall, this is one of the best business ideas in the world.
Dunkin Doughnuts (DNKN) -- Dunkin makes great pastries, fantastic coffee, exceptional bagels, tasty sandwiches, and some of the best glazed doughnut holes in the world. However, the stock could leave investors with a doughnut of their own or a hole in their portfolio because of valuation issues with the company's pricey common stock. At 49X earnings, Dunkin shares could leave investors with sugar high withdrawal once the IPO mania subsides and the reality of valuation returns to the marketplace. In fact, this stock could crash 50% and still be considered somewhat expensive from a traditional PE ratio/valuation point of view. Green Mountain Coffee Roasters' shares plunged some 34% on Wednesday after the company missed revenue estimates. It's clear that the highly speculative momentum names are at risk of severe multiple contraction even though the revenue growth is substantial. While Dunkin is an iconic brand, just like Green Mountain, the stock is markedly overpriced.
After witnessing and writing about the implosions of Netflix, Green Mountain, OpenTable, Travelzoo and others this year, we are pleased to warn readers about these three investments and urges investors in these stocks to consider alternatives.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.