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Are These Internet Stocks Too Risky?

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Prudent investing often invokes derision from the investing community.  Value investing doesn’t get much air time from the financial media.  Instead, it’s easy to get carried away with the hot stocks of the day.  Disciplined investing means following the ideas proposed by Benjamin Graham, whereby the investor diligently avoids paying too much for a stock’s earnings and dividends.  Legendary investors Warren Buffett and Charlie Munger have invested this way their entire careers.  When I evaluate a stock for investment, I ask myself what the fathers of value investing would think of my idea.  In that vein, despite the high-flying statuses of Amazon (NASDAQ: AMZN), Salesforce.com (NYSE: CRM), and Priceline.com (NASDAQ: PCLN), it’s too difficult to ignore their extremely lofty valuations.

Great Companies with Not-So-Great Valuations

Amazon is the online retailing juggernaut whose growth story is indeed incredible.  The company has grown to a market value of more than $120 billion despite an operating history of just 19 years.  Amazon’s sales have grown at an amazing 34% compounded annually over the last four years.  Top line growth has been fantastic, but the lack of profitability is what concerns me.  Clearly, high-growth companies spend most of their sales on reinvestment to build the business.  However, investor returns are dependent on earnings and dividends, neither of which Amazon provides.  Earnings per share over the last four years grew at a rate of just 4.85% compounded annually.  For fiscal year 2011, Amazon reported earnings per share of $1.39.  Nevertheless, the stock has been on an absolute tear:  shares have almost doubled over the last three years and are sitting near its all-time high.  As a result, shares are trading at 194 times 2011 earnings, and the stock has a price-to-book ratio of more than 15 times.  I’m a huge fan of Amazon’s business and have utilized it many times, but from an investment perspective, such high multiples keep me from buying the stock.

Salesforce.com provides cloud computing and social enterprise solutions to businesses and industries worldwide.  Like Amazon, Salesforce has grown revenues at a high rate—sales have increased more than 31% compounded annually since 2008.  Unfortunately, that hasn’t translated into profits. Salesforce reported a loss of 9 cents per share in fiscal 2012.  The company’s most profitable year was 2010, when the company reported $0.65 per share in profits.  However, that hasn’t stopped the share price from exploding from the low $20’s in the depths of the financial crisis to its current level of more than $160.  Salesforce has a very rich valuation, with a price-to-book ratio of almost 12.

Priceline operates as an online travel company through its namesake website.  To its credit, Priceline is solidly profitable:  Priceline reported fiscal 2011 diluted earnings of $20.63 per share.  That means it is the most modestly valued of the three, with shares trading at ‘just’ 32 times 2011 earnings.  Priceline got off to a great start in 2012, with total revenues rising more than 20% during the first nine months of the year.  Even so, it’s hard to make the case that Priceline isn’t full valued with shares trading at 7 times sales and 9 times book value.  Shares are about 12% off their 52-week high, but have still climbed more than 50% in two years.

The Bottom Line

All of these three stocks have revolutionary businesses with high growth rates in sales.  Their stocks are even more impressive, having risen at rates far better than the overall market.  I admire each of these three companies and am sure that their products are well-liked by their customers.   However, it’s important for investors to separate the emotional from the rational when making an investment decision.  No matter how compelling a company’s story might be, an investor should rarely pay those kinds of multiples for a company’s earnings.  There’s little room for error when a company is trading at double digit multiples of sales and book value.  It’s true that these stocks can continue to run higher; there is nothing preventing a full-valued stock from becoming over-valued.  But for me, I’m willing to miss out on further upside in these stocks in exchange for not taking the risk inherent in such high valuation multiples.    


 


Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Priceline.com, and Salesforce.com. The Motley Fool owns shares of Amazon.com and Priceline.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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