Another plunge for Twitter (NYSE:TWTR) shares today, after Morgan Stanley (NYSE:MS) downgraded the stock to underweight from equally-weight on Monday. The stock fell almost 10% this week. This is the second time in two weeks time that Twitter's share price plunges after an analyst downgrades the stock. Last time, several articles stated that the Twitter bubble had burst (for example: this article and this article). Several investors argue that Twitter and other internet stocks are a bubble that is waiting to deflate, or already started to deflate. In my opinion, Twitter is not a bubble, nor are other internet stocks like Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), LinkedIn (LNKD), Baidu (NASDAQ:BIDU), Yelp (NYSE:YELP), Groupon (NASDAQ:GRPN), Tripadvisor (NASDAQ:TRIP) and Zynga (NASDAQ:ZNGA). In this article I provide arguments why I believe the current valuation of internet and social media stocks do not qualify as a bubble at this moment, given the current valuations and the behavior of market participants.
How to define a bubble?
First, it is important to define the term 'bubble'. Investors might be confused about the term 'bubble'. I refer to Robert Shiller, a recipient of the 2013 Nobelprize in Economics. Robert Shiller is well known for predicting bubbles. For example, he predicted the latest housing bubble that indirectly caused the worldwide financial crisis. During a television interview in the Netherlands he said: "When I look at bubbles, I look at two things. First, I look at all kinds of ratios. Second, I look at the behavior of market participants." This means that a bubble occurs when the ratios do not make any sense and market participants ignore the red flags.
Which ratios to look at?
The next questions is: which ratios do you have to look at? Well, that depends on the object for which you want to make a statement. In this case, the object is the valuation of internet and social media stocks. Most common ratios to valuate these stocks are the price/earnings ratio, price/earnings to growth ratio and price/sales ratio. Several articles refer to the average revenue per active user as a ratio for social media stocks (for example: this article and this article). This ratio could also be used to make a statement about the valuation of the social media stocks like Twitter, Facebook and LinkedIn.
Since I would like to make a statement regarding both internet and social media stocks, I did not use the average revenue per active user as one of the ratios in the article.
How do market participants behave?
An important factor in my analysis, whether the internet and social media bubble exists, is the behavior of market participants. This is more a soft variable compared to the hard ratios. Generally, it takes common sense to recognize irrational behavior. A good example of irrational behavior is when investors completely ignore the bad news and exclusively focus on the good news. Further, irrational behavior is often fueled by greed and jealousy. As Gordon Gekko proved to us: "Greed is good", but it will get you in trouble in the end.
Does the internet and social media bubble exist?
Following Robert Shiller's suggestions, I look at ratios and the behavior of market participants in order to make a statement regarding the potential internet and social media bubble.
First, I look at the forward P/E ratio, PEG ratio and P/S ratio (see table below). At first sight, these ratios indicate a potential bubble. The forward P/E ratios of the ten companies in the table are higher compared to the average forward P/E ratio of 16.65 for all S&P 500 stocks (according to the Wall Street Journal). On the other hand, the PEG ratios show a more optimistic image. A PEG ratio between 1.00 and 3.00 is not unusual and five out of ten companies in the table score a PEG ratio between these two values. The P/S ratios fluctuate a lot and it is difficult to qualify the outcome of this ratio. However, Twitter's P/S ratio seems to be extremely high compared to the other stocks.
|Company||P/E ratio*||PEG ratio*||P/S ratio*|
* Ratios based on Monday's share prices
Second, I look at the behavior of market participants. My first indicator is the average analyst recommendation for the ten stocks. Yahoo! Finance offers mean analyst recommendations between 1.00 (strong buy) and 5.0 (sell). The average analyst commendation for the ten stocks is 2.36. This value indicates that analysts recommend to buy these stock to some extend. However, it does not indicate undue optimism. Further, analysts are not afraid to downgrade the stocks. In fact, Twitter faced several downgrades in the past two weeks.
Investors do not ignore (potential) red flags either. Stocks of the internet and social media companies fall hard, when they face a downgrade or miss the market's growth expectations. This implies that investors are cautious and react to bad news. Cautious investors, ready to react to bad news, do not match the image of a bubble market that is fueled by greed and jealousy. Further, I see the rising short interest in stocks like Twitter (see this link) as another indicator that the internet and social media stocks are not forming a bubble at this moment.
At first sight, the internet and social media stocks seem a bit expensive. This indicates an overvaluation of the stocks and a potential bubble. However, some of the ratios point out that these stocks are not forming a bubble at this moment. This is confirmed by my observation of the market and its participants. Analysts and investors seem to make rational investment decisions and the market is not fueled by greed and jealousy.
Overall, I do not see internet and social media stocks fuel a next bubble right now. Although some stocks may seem expensive, investors and analysts are ready to act on bad news. The investors and analysts judge the internet and social media stocks individually and not as a whole. The good performing stocks get rewarded (share price goes up) and the poor performing stocks get punished (share price goes down).
Let me be clear that this article is a general look at the bubble discussion regarding internet and social media stocks. This article provided arguments why I think these stocks are not forming a bubble at this moment. Despite my view on the current valuation and the behavior of market participants, I would like to point out that is possible that the internet and social media bubble may inflate in the future. Finally, this article does not recommend to buy or sell the stocks mentioned.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.