A very strange event is occurring in the market, in one particular space, internet companies. It has to do with the valuation/expectations relationship that creates balance and determines performance in the market. For the most part, this balance is correctly valued in the market, however when it is not, it indicates to value investors that A) a stock may be undervalued or B) a stock may be overvalued. But with internet based companies this system for identifying value is on a field to itself, and is challenging the method for identifying value.
In the market, expectations determine performance/valuation. For example, if we expect unemployment to be 8.0% and it's found to be 7.8% then the market goes higher. On the other hand, if we expect 8.0% and it's 8.2% then the market trades lower, as employment has direct ties to economic growth. The market is a reflection of all indicators and corporate earnings that come together to create valuation in the market. When the economy is strong valuations are high above fundamentals (such as revenue and income). When there are questions in the economy the market trades much closer to fundamentals, as our expectations are low and we don't place a high level of confidence that fundamental growth will continue.
The relationship between expectations and valuation/performance has always existed, and overall has proven itself to be a great system. However, among internet based companies this system is being challenged, and companies that trade far beyond fundamentals are exceeding mediocre expectations, and then trading higher. It's almost as if unemployment in the U.S. were 11% and the Dow Jones was valued at 20,000. The high unemployment suggests economic hardships, therefore the Dow should be trading lower, perhaps valued for a recession, therefore a high valuation wouldn't make sense. However, with internet companies this is simply not the case, and the expectations compared to performance simply don't make sense and proves that investors are buying on hope rather than fundamental progress.
Over the last 24 hours both Yelp (NYSE:YELP) and Pandora (NYSE:P) have traded higher by a considerable margin, although the companies are different by nature, both fall into the category of high profile internet based companies (although I'd argue there's much more of a business to Pandora). Pandora, which trades with a price/sales of 5.60 and a forward P/E ratio of 252, announced that listener hours increased 80% year-over-year and revenue jumped over 50% while the company broke even in terms of income. Yelp, which is much more expensive, has a price/sales of 10.42 and a forward P/E ratio of 559.25, and traded higher by nearly 23% on Wednesday after growth prospects enticed insiders to hold their shares despite the lockup expiration, therefore causing shorts to cover their shares.
Both Yelp and Pandora have increased by a significant amount of value over the last 24 hours, following different circumstances. However, in Pandora's case, shouldn't 50% revenue growth be expected with a price/sales of 5.60 and a forward P/E ratio of 252? And is there any news to warrant a 23% increase in value for a company trading with a price/sales ratio of 10.42? If history is any indication then the answer should be "no"! When a company trades with a gaudy valuation it is because high expectations are expected, and then once high expectations aren't met the stock should trade lower, that is if this class of companies were valued with the same rules as the rest of the market.
I have said for the last year that companies such as Pandora, Linkedin (NYSE:LNKD), and Zillow (NASDAQ:Z) are a no win situation for everyone. These companies would have to double growth every year for the next 2-3 years just to present a normal valuation compared to fundamentals, while maintaining its current price. Because after all, there are many companies in the technology sector with equal to or greater growth and none trade with the same valuations as high profile internet based companies. For example, if Pandora was to trade with a valuation similar to Sirius XM (NASDAQ:SIRI) it would trade with a market cap of about $600 million, or a price less than $4. If we compare Yelp to Google (NASDAQ:GOOG) the distinction would be about the same, perhaps greater.
I don't imagine that anyone would argue that companies such as Yelp, Pandora, Facebook (NASDAQ:FB), and Linkedin aren't overvalued, as there is no investment paradigm to suggest these companies are presenting value. Therefore, with that being said, what is it that constitutes such high valuations, and challenges all the basic rules of performance and valuation in the market? I believe the answer lies in the perception of these companies, and the large investments being made in the infancy of their development.
Back in May the Wall Street Journal published a piece entitled "The $1 billion Start-Up Club" which explains the reasons behind such gaudy valuations. In the piece, the journal identifies 20 start-up internet based companies that are valued at over $1 billion, thanks to large investments from venture capitalists. As a result, with large values, or investments, in early development these companies trade with massive valuations once brought to the market. However, some of these valuations are just insane. For example, "Better Place" is a supplier of electric-vehicle service stations and charging facilities and it has a valuation of more than a billion dollars, and who knows if it returns revenue. This number of 20 start-ups being worth over $1 billion surpasses the dotcom era when there were only 18 with similar valuations, and the frightening fact is that these new companies are being created everyday.
I suppose my problem with these internet startup companies, and the valuations, is that I can not fundamentally determine how any would be worth more than a company such as Spectrum Pharmaceuticals (NASDAQ:SPPI), a company with a market cap of $700 million, revenue of $230 million, and earnings growth of 150%. Some of these internet based companies are valued at over $1 billion without any net income, and then in the case of Pandora trade higher by 20% after posting earnings that are somewhat mediocre considering its valuation. The fact of the matter is that with the valuations of high profile internet based companies high expectations should be built into valuations. It should be expected that these companies are posting revenue growth of 50%-100% year-over-year, not considered a beat, therefore perhaps being a problem with analyst expectations.
Ultimately, the only person that can decide, and should decide, on an investment decision is the individual investor. Therefore, if there is some form of fundamental analysis that finds this group of companies as undervalued then by all means an investment should occur. My question, when defending a large valuation, is what reasons are there to believe the company can maintain growth? Because with forward P/E ratios in excess of 100 you are betting that a company, based on the internet, is going to continue growing and by a large margin year-over-year. An investor who invests in these companies are also sacrificing immediate gains, as sooner or later fundamentals much compare to metrics (a good example would be Google since its IPO). In my opinion, there is no reason to believe that any of the internet based companies will stand the test of time. We've already been through this era, and during the dotcom there were many public companies, and only Amazon (NASDAQ:AMZN) and Google stood strong. In the end I think it's a no win situation, that will ultimately result in loss, because with most of these companies being only a few years old, and relying on user growth, it is very likely that most will become known as a fad, and that very few will emerge as legitimate companies, therefore the trading tendencies for most of these companies will result in significant loss.
Disclosure: I am long SPPI, GOOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.