Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



Why Fantastic Stock Performance Can Hurt a Company

Hype is to stocks as adrenaline is to the human body: Just as adrenaline can make us forget about pain or consequences for a brief moment -- whether it's a broken leg or a first kiss -- hype can make the market forget about a company's ills, whether it's a broken business model or overvaluation.

Why is it so bad for a company to have some hype? And what should you watch for with a company that you think is too hyped?

Getting hyphy
Good stock performance can beget good stock performance based on momentum. As a Wall Street Journal article explains: "These momentum trends in markets have more to do with the faddishness of human behavior than the fundamentals of economics and balance sheets. In essence, investors often flock to the stocks that have been going up, which tends to propel them further." This can cause a few issues.

For management whose compensation is tied to stock performance, a highflying share price might draw attention away from more important measures of performance. An increasing number of executives' pay is tied to performance as opposed to salary and options, at 50% of total compensation in 2012 versus 35% in 2009.

An additional pain for management is when the overvaluation collapses. Even if stockholders' returns on paper were unjustified, they may hold management accountable for the evaporation of the hyped-up value, calling for new leadership. To prevent this, managers might be pressured to maintain the high share price through unscrupulous manipulation of financial reports. For example, while it probably owed more to lax standards, Groupon (NASDAQ: GRPN  ) suffered from a few accounting setbacks. It went public with a market capitalization above $15 billion and quickly struggled to live up to that value. It then had to restate its first public earnings report, reporting lower revenue and a larger loss. Eventually CEO and founder Andrew Mason was fired at a time when the company was worth around $3 billion.

Managing the hype
A company can hide behind this hype for awhile, but the sign of a good investment is when management notes that its stock price is a distraction -- that is, when it calls out its own overvaluation. After all, when the hype inevitably wears off, the company will need to perform that much better to regain respect from the market with the near-perfect execution investors had priced into it.

Recent examples of this are Elon Musk of Tesla (NASDAQ: TSLA  )  and Reed Hastings of Netflix (NASDAQ: NFLX  ) . While the historical price-to-sales ratio for the S&P 500 is about 1.4, Tesla rocks a 12.7 P/S ratio, and Netflix's P/S ratio sits at 4.8.

Musk said that Tesla's stock was overvalued in August and October, and according to CNBC, he recently noted: "I went on record saying that the price is higher than we have any right to deserve, that said, I do think that long term, the value of the company will be well in excess of that. But to give us that valuation is to have a lot of faith in our future execution."

Hastings made similar comments, according to Yahoo! Finance, saying, "Every time I read a story about Netflix is the highest appreciating stock in the S&P 500 it worries me because that was the exact headline that we used to see in 2003." In 2004, Netflix shares hit a peak around $39 per share before falling to $9 per share.

Honesty over hubris
Such honesty of management reveals a company focused on long-term success, instead of driving up the stock price with little respect for future consequences. It's also no surprise this honesty comes from companies run by their founder, who not only have a great deal of wealth tied up in their firms but also have passion and respect for their work.

The adrenaline of quick jumps in value can take their toll over time, but proper management can mitigate the consequences.

3 Hype-Free Picks
It's no secret that investors tend to be impatient with the market, but the best investment strategy is to buy shares in solid businesses and keep them for the long term. In the special free report, "3 Stocks That Will Help You Retire Rich," The Motley Fool shares investment ideas and strategies that could help you build wealth for years to come. Click here to grab your free copy today.

Read/Post Comments (0) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2727728, ~/Articles/ArticleHandler.aspx, 9/29/2016 1:35:06 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 3 hours ago Sponsored by:
DOW 18,339.24 110.94 0.61%
S&P 500 2,171.37 11.44 0.53%
NASD 5,318.55 12.84 0.24%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/28/2016 4:00 PM
GRPN $5.26 Down -0.07 -1.31%
Groupon CAPS Rating: *
NFLX $97.48 Up +0.41 +0.42%
Netflix CAPS Rating: ***
TSLA $206.27 Up +0.46 +0.22%
Tesla Motors CAPS Rating: **