How Investors Can Profit from These Frightful Valuations

Investors Can Profit from These Frightful ValuationsThese are some scary times for holders and chasers of some of the high-volume brand-name momentum stocks, especially in the Internet services area. (Just in time for Halloween…)

While I always like to trade and follow the trend, I’m concerned with some of the superlative moves in the stock market and the resulting excessive and non-realistic valuations in the Internet area.

While I don’t want to wreck the celebratory mood on Wall Street, I highly recommend investors take a step back and really look at some of the euphoric buying we have been seeing specifically with the Internet stocks. It reminds me a bit of what happened in late 1999 and early 2000, prior to the market implosion.

We are clearly witnessing some unjustified buying in Internet stocks as overzealous traders seek profits. The problem is that the pro traders generally are a step ahead and know when to exit.

You don’t want to be caught in a massive stampede to the exits. I’m not saying it will materialize, but it’s something you have to keep in mind.

In my previous article, I discussed the upcoming initial public offering (IPO) for Twitter as it begins its road show this week, drumming up business for what will likely be its overpriced IPO and the frenzy to follow. (Read “How Small Investors Can Still Get a Piece of Twitter.”)

The current valuations I’m seeing with numerous Internet stocks in the social media space is outlandish and would make Warren Buffett shake his head. Buffett may admit to not understanding technology and the Internet, but he clearly knows a thing or two about valuations.

Facebook, Inc. (NASDAQ/FB), for instance, has been burning up on the charts since declining to the $18.00 level in November 2012. The momentum traders have driven the stock up 146% over the past 52 weeks versus a comparative 24.62% advance by the S&P 500. Even when you look at the stock’s expected beta of 2.10, the rise in Facebook’s price is unwarranted.

Trading at nearly 50 times (X) its estimated 2014 earnings and 20X trailing sales, the valuation of Facebook is ridiculous. In comparison, Google Inc. (NASDAQ/GOOG) trades at 19.5X earnings and 5.9X trailing sales, respectively. I have always said Facebook was overpriced, but the stock market clearly feels the company will deliver exceptional results in the future.

Also on the high end is Internet service review site Yelp, Inc. (NYSE/YELP), which trades at an astounding 255X its estimated 2014 earnings. What a crazy valuation! To make matters worse, the company’s price-to-earnings-growth (PEG) ratio is negative 34, which means the company is estimated to see lower earnings growth. In my view, negative PEG ratios are red flags.

The bottom line: there are numerous other overvalued Internet social media and tech stocks that are vulnerable to excessive selling, especially if the market bias reverses. The use of put options or aggressive shorts on some of these overpriced stocks could pay off in some circumstances.