One of the first concepts investors tend to turn to are the brands they’re most familiar with. New investors often spring for specific companies that stand out to them in their own lives. Perhaps such inspiration came from the flight they just departed from that had the blue insignia of JetBlue (JBLU) plastered across the plane’s body. Maybe it was the Big Mac they just ate at the nearby McDonald’s (MCD)? In either case, the person often incorporates their familiar experience with the company’s performance in the real world by projecting upon the stock market a full expectation of a similar reality.
Herein lies the underlying problem: The market reality and the real world reality are often two separate concepts altogether. The market is forward-looking, irrational, and often underpinned with a sense of valuation that often includes a multiple based upon a company's earning potential. Likewise, observation of real world performance isn't always able to clearly show the full picture of a company's assessable performance. Best Buy's (BBY) retail stores might be prominently found on every corner, but the consumer might not be aware of thinning profit margins which can reflect an entirely different picture of retail leadership when it comes to how the company's stock might trade.
One of the more commonly thrown-around quotations from investing legend Warren Buffett has been the simple mandate to “Invest in what you know.” While I am a full supporter of this concept, such simplistic advice is often dangerous for investors who are five minutes removed from opening their first brokerage account. New investors often misquote this concept as they equate familiarity with a company's product with an understanding of the company itself. It's often prudent to remind such people that they are not Warren Buffett, and what they think they might know isn't always the case - until they've cracked open a company's financials to at least get a basic picture of the company.
This was the case with the recent popping of stock sensations Netflix (NFLX), SodaStream (SODA), and OpenTable (OPEN). With investors riding the hyped up wave of growth momentum, willing to give Netflix a $12 billion+ market capitalization towards its peak, anyone looking at the company's balance sheet might have had a few more reservations when they considered the mere $334 million in stockholder equity that the company carried in June of 2011. They certainly would have overlooked the negative tangible asset value that was being built into the company as debt rose and the more subjective intangible assets began to grow.
The same could be said about SodaStream and OpenTable, two popular brands in the real world filled with promising growth potential. SodaStream appeared primed to turn basic water into a high margin product. OpenTable was ready to streamline restaurant reservations into a marketable social craze. Yet, in both cases, the value investors were prescribing to these companies on the basis of that growth far exceeded the appropriate reality of their intrinsic valuations, in part measured by the company's assets. With exuberant forward price-to-earnings ratios often jumping well past 40x forward earnings, the growth momentum wasn't just being considered, but being entirely relied upon in order to sustain the share prices given.
As the these stocks tumbled of late, such recent examples of bubble-popping give rise to questions about other similar scenarios. Some of these can be found today in the newly public social media plays and cloud computing companies. Investors watching the financials of companies such as Groupon (GRPN), NetSuite (N), Salesforce (CRM),and LinkedIn (LNKD) might do well to question whether such companies can sustain their growth momentum that is currently being relied upon to justify current valuations. As of January 4, LinkedIn, for example, still sported a forward P/E of 118 on analyst expectations of $0.52/share for the upcoming year.
The advent of social media IPOs in particular stand to be alarming considering the retail investor's familiarity with the product. As most retail investors often act like new investors who are unable or unwilling to crack open a company's financials, the popularity of the products themselves appear to allow for high share prices that are currently being seen today. One only begins to wonder what Pandora's Box might hold for the expected and eventual IPO of Facebook.
The jury might still be out on many of the aforementioned companies. After all, some might still be justified growth plays. Yet the question still remains how long a perceived value that has strayed from a commonly assessed underlying valuation can stay afloat. In any case, investors might want to question the logic in waiting around to find out if growth momentum is said to to be realized before it actually is.