Why You Should Avoid These Overvalued Stocks

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 |  Includes: AMT, AMZN, CMG, LNKD, NFLX
by: David Zanoni

We’ve seen what can happen to an overvalued growing company like Netflix (NASDAQ:NFLX) when its CEO’s business decision was negatively received. Netflix fell from a high of $304 down to a low of $62 this year. Netflix had a PE ratio of 68 when it was in its peak overvalued state back in July 2011.

Shareholders of overvalued stocks need to be aware that the downside risk can be larger than the upside potential. If you have experienced large gains in these stocks, consider taking profits and replace them with stocks that are undervalued.

Keep in mind that some form of a negative catalyst would have to take place to trigger a sell-off in these names. Negative catalysts could be an earnings miss, escalating costs, poor management decisions, accounting issues, new regulations/taxes that would harm the business, etc.

Amazon (NASDAQ:AMZN) currently has a trailing PE ratio of 103, a forward PE ratio of 96, and a PEG ratio of 7.08. This is a high state of overvaluation. Amazon did have an earnings miss for the third quarter 2011 with an EPS of 14 cents as compared with the expected estimate of 24 cents. This miss took the stock from $246 down to the low $180s. It has since recovered to $196. That’s still 20% below its high.

Another negative trigger such as another earnings miss would cause further selling off of its stock since AMZN is still in an overvalued state.

LinkedIn (NYSE:LNKD) has a trailing PE ratio of 1,017, a forward PE ratio of 297, and a PEG of 29.63. This is way overvalued. However, the company does have a few things going for it. It has zero debt, an operating cash flow of $125.6 million, and cash of $387.7 million. It is expected to grow earnings annually at 82.36% for the next five years.

The high level of overvaluation puts LinkedIn at a great downside risk. If it misses its earnings estimates, there could be a significant sell-off in the stock.

Chipotle Mexican Grill (NYSE:CMG) has a trailing PE ratio of 52.45, a forward PE ratio of 39.07, and a PEG ratio of 2.44. Although its valuation is not as extreme as Amazon’s or LinkedIn’s, investors do need to be cautious of the downside risk.

Chipotle’s business is currently solid and growing. It has a healthy EPS of 6.42, an operating cash flow of $383.86 million, a total cash figure of $444.63 million, with only $3.69 million in debt. It has grown earnings annually at 39.95% for the past five years and is expected to grow earnings annually at 20.24% for the next five years. However, since the stock is richly valued, it will have to consistently meet or exceed earnings expectations to maintain its high stock price.

American Tower (NYSE:AMT) has a trailing PE ratio of 85.94, a forward PE ratio of 41.76, and a PEG ratio of 3.24. This developer and operator of communication towers is currently overvalued with significant downside risk. AMT does have some positives: an operating cash flow of $$1.1 billion, a profit margin of 11.76%, and an operating margin of 37.46%.

American Tower just had a downward earnings revision from 37 cents a share to 36 cents a share. Its earnings growth is expected to be a negative (7.7%) for the year. It has grown earnings annually at 59.09% for the past five years and is expected to grow earnings annually at 21.77% for the next five years.

Recommendation

If you currently own these stocks or stocks with similar overvaluations as indicated by high PE and PEG ratios, you should consider selling out of the position, or sell a portion of your position. Any negative news about the company whether it be about a product, an earnings miss, a poorly received business decision, escalating costs, etc. can have a magnified effect on the downward movement of the stock. These stocks may continue to ride higher for a bit, but eventually they will run out of steam. There are many other undervalued stocks in the market to choose from that have low downside risk. Feel free to read my other articles for undervalued stock ideas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.