A little more than two months ago, I decided I would step out of the box and stop living by other Wall Street analysts' rules. Instead, I chose to create my own formula that would look at book value, price-to-sales, and price-to-cash-flow to determine the market's most overvalued stocks. You can learn more about the criteria and the thought process that went into my one-of-a-kind formula, dubbed TMFULOI, by clicking here.
With just over two months under my belt since my first selections, the results can be described as nothing short of a resounding success. Here's how the five most overvalued stocks have performed since that first article:
Performance Since April 3, 2012
|Baidu (Nasdaq: BIDU )
|LinkedIn (NYSE: LNKD )
Source: Yahoo! Finance, author's calculations.
No doubt about it; I may be on to something here! Mitek is dealing with patent issues that have cost it much of its market value in the wake of that article. The remaining stocks, minus LinkedIn, which has held up relatively well, have fallen considerably more than the overall market indexes.
With that said, I'm going to give this another try and see how useful my TMFULOI valuation metric might be on a new round of overvalued companies. This time I'm also going to make an exception and allow one biotechnology stock to infiltrate the ranks, as it does have a regularly sold drug (i.e., it won't skew the rankings).
Admittedly, with the market having corrected, the pickings were much slimmer than last time, but I still managed to wrangle five companies that fit the bill and are markedly overvalued. You'll see some familiar names, but we also have some new additions:
|Alexion Pharmaceuticals (Nasdaq: ALXN )
|Gold Resources (AMEX: GORO )
|SolarWinds (NYSE: SWI )
Sources: Motley Fool CAPS Screener, Morningstar, author's calculations. Data as of June 8, 2012.
The first thing you'll notice is that it's not all tech companies this time. We have biotech and mining, as well as higher-growth tech stocks represented this time.
LinkedIn makes its second appearance on this list, vaulting to the No. 1 spot -- although down in total TMFULOI points from its previous ranking. Despite the slight drop in price to cash flow, LinkedIn still seems like fool's gold to me. Premium subscriptions, which are the key to driving LinkedIn's margins higher, rose 91%, but as a percentage of total revenue, premium subscriptions fell to 20% from 21% in the year earlier. I also wouldn't overlook the fact that LinkedIn's focus on connecting business professionals is highly dependent on the economy getting better. A weak jobs report in May could take some of the wind out of LinkedIn's sails.
Normally, I don't consider biotechnology stocks because their revenue generation is often erratic. That isn't the case for Alexion, which is currently sporting a market value north of $17 billion despite having only one drug approved by the Food and Drug Administration. Soliris, which treats paroxysmal nocturnal hemoglobinuria (a cause of anemia), brought in nearly $1.1 billion in annual sales last year. My concern is that its lack of pipeline diversity could be its downfall. The company's five other studies currently under way also involve the combined use of Soliris, giving it few avenues to succeed if Soliris doesn't find success in alternate trials. Remember, drug patents don't last forever, and neither will Alexion's valuation, I predict.
Baidu has made serious strides to remove itself from being listed, using my TMFULOI metric, as one of the market's most expensive stocks. Its TMFULOI score has been cut nearly in half in just two months, thanks, in part, to another strong quarter of sales and cash flow growth highlighted by a 75% increase in total revenue. However, I remain skeptical of Baidu's valuation considering that China's growth is still slowing, which could weigh on advertising spending, and the fact that expenses keep rising in line with revenue. I understand the need to expand its reach, but its additional costs could become a burden when its growth rate slows. Its valuation is getting more reasonable, but it still is a far cry from a buy in my opinion.
Although I'm bullish on the outlook for gold and silver miners, Gold Resources joins a small handful of miners that I'd just as soon pass on. The company spent a long time building out its mines in Mexico and only last year enjoyed its first year of production. Mining costs have remained exceptionally low, allowing Gold Resources to join many other mining companies in paying out a quarterly dividend. While it might seem like the perfect company, I doubt it can keep its mining costs this low for any extended period of time, and I'm concerned its valuation will take a hit if compared side-by-side with peers Newmont Mining and Silver Wheaton, which boast markedly lower forward earnings multiples and price-to-cash-flow ratios. It isn't the most obvious sell of these five stocks, but it nonetheless is a stock I wouldn't want to own.
SolarWinds holds the rare distinction of being the only company listed in April whose TMFULOI score has actually gone higher! What's making this IT software producer more expensive? As the Fool's Rex Moore outlines, it's the company's disruptive software, which allows ease of use for its clients and gives them an edge over their competitors. However, I feel it'd be ignorant to assume its much larger competitors won't adapt their software to a similar platform or simply use their huge marketing budget to squash SolarWinds in its tracks. I predict that at some point in the near future, SolarWinds' growth will slow from its traditional 30% growth rate and expose its 30-plus forward P/E and price-to-cash-flow of 27.6 to the elements of a fickle and unforgiving market.
There you have it: round two of the five most overvalued stocks according to my handy-dandy TMFULOI metric. We'll check back in a few weeks to see if there really is something to this metric, or if the last two months were just a fluke. I'll also be adding what few companies aren't already in my CAPS portfolio as underperforms to show my conviction that these valuations simply can't hold.
If making things up as you go along isn't your thing, then the Motley Fool's latest special report, which highlights our chief investment officer's "Top Stock for 2012," might be right up your alley. Find out for free which stock has him buzzing with excitement.
Feel free to keep track of my progress by adding these stocks to your free and personalized watchlist so you can keep track of the companies that matter to you!