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How to Tell If a Stock Is Overpriced

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

How do you tell if a stock is overpriced? How about when an earnings miss of a penny causes the stock to plummet by 25%. That's exactly what happened with Rackspace (NYSE: RAX) after reporting its Q1 results a few days ago. Even with revenue increasing by 20% and net income increasing by 16.4% year-over-year, a slight miss of analyst expectations led to a gargantuan decline in the stock price. Expectations were clearly set pretty high.

What does Rackspace do?

Rackspace is an IT hosting company with a big focus on the cloud. In the past web sites and applications were often hosted on dedicated servers. This made scaling difficult as more servers would need to be added and integrated, and if a server went down the whole site went down with it. But the cloud allows for the site or application to reside on a large array of servers, along with other sites. If a single server fails the application will continue to function because there is often redundancy built in, and scaling the application simply involves allocating more resources for it.

Rackspace is one of many companies that offer this kind of hosting environment. More and more companies are moving to this type of hosting as it can greatly reduce IT costs, and companies like Rackspace have benefited greatly from this migration.

The growth story

Since 2008 Rackspace has grown its revenue at an annualized rate of about 25%, with net income increasing by nearly a factor of five or 48% annualized. This is impressive, but you have to remember that Rackspace was a much smaller company 5 years ago. It's much easier for a small company to grow at these kinds of rates than it is for a large company, and Rackspace has now hit a size where it will be difficult to maintain this kind of growth.

Growth should still be quick as demand for cloud-based hosting rises, but growing faster than the industry will become more difficult over time. And that's to say nothing of the competition.

Battling giants

There are quite a few hosting companies that compete with Rackspace, but the two that are most worrisome are Amazon (NASDAQ: AMZN) and Microsoft (NASDAQ: MSFT).

Amazon web services is the current market leader in cloud infrastructure services, with Rackspace at number two. Amazon is a company willing to completely sacrifice profits for growth, and it shows with the aggressive price cuts enacted by the company. Rackspace's Q1 earnings came in below expectations because the company was forced to cut prices in response to Amazon's aggression, and it seems that Amazon won't be letting up anytime soon. Amazon is running its business with margins close to zero, making it very difficult for Rackspace to compete.

And then there's Microsoft. Microsoft's Azure cloud platform competes directly with Amazon's web services and Rackspace, and having a company with the resources of Microsoft competing with you is never a good thing. Recently Microsoft announced that it would match Amazon web services prices for commodity services, further pressuring Rackspace's prices.

It's hard to bet on Rackspace with both Amazon and Microsoft aggressively slashing prices. Amazon has claimed some big customers for its web services, like reddit.com and Yelp, and you can see a full list here. And with Microsoft's price cuts I would expect Azure to grow rapidly as well. It will be very difficult for Rackspace to grow anywhere near its historical rates with the kind of competition its facing.

What were people thinking?

Rackspace stock traded as high as $81 per share at the beginning of this year, then proceeded to plummet to around $45 per share. It recovered slightly to the low $50s, but now it sits just below $40 per share after the Q1 earnings report.

This is a stock that had an EPS of $0.75 in 2012. It was trading at a P/E ratio of over 100 at the beginning of the year, and before this earnings report the P/E ratio was still a staggering 70. Even now, after the big drop, the P/E ratio still sits at around 53. The valuation has gone from being absolutely insane to just marginally insane.

If the company could actually grow earnings at 50% per year for the foreseeable future then maybe these high ratios are justified. But it can't, and it won't. Growth will almost certainly slow as the company is faced with well-funded and aggressive competition. Even if EPS could be grown at, say, 20% annually a P/E ratio of 53 is bonkers, let alone a ratio of 100. This is what happens when you pay 100 times or 70 times earnings -- you get burned. And if you pay 53 times earnings now you'll likely get burned again.

The bottom line

When a stock sinks 25% because earnings miss by a penny then it's likely dramatically overvalued. Rackspace is a fine company with good margins but it has been bid up to outrageous prices. Even after the 25% drop it's still way too expensive. Rackspace was a ticking time bomb at $80 per share, it was a ticking time bomb at $53 per share, and it's likely a ticking time bomb at $40 per share. The next time the company disappoints, expect more pain.

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Timothy Green owns shares of Microsoft. The Motley Fool recommends Amazon.com and Rackspace Hosting. The Motley Fool owns shares of Amazon.com and Microsoft. 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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