Rocket Stock or Dud?

"The bigger they are, the harder they fall." It's the worst nightmare of every investor in today's market -- buying a rocket stock just before it takes a nosedive.

Now I readily admit that sometimes, stocks rise for a reason. But sometimes, the rise becomes the reason. No matter how often we caution them not to, investors do have a habit of buying "hot" stocks, and trusting momentum to keep 'em moving upwards.

Problem is, if the price goes up too much, even a great company can turn into a lousy investment (and if the company was less than great in the first place...) Below I list a few stocks that may have done just this. Stocks that, according to the smart folks at finviz.com, have more than doubled over the past year, and just might be ripe to fall back to earth.

Companies are selected by screening for 100% and higher price appreciation over the last 12 months on finviz.com. Five stars = highest possible CAPS rating; one star = lowest. Recent price and CAPS ratings from Motley Fool CAPS.

Tech's back, baby!
... and with a vengeance. While the market's recent hissy fit may have raised doubts about the broadness and duration of the bull market's run, it's hard to call the gains at these three companies anything other than phenomenal. VMware, up 119%. Cree, 154%. Baidu, 195%! And all in the space of a single year.

But is there more in store? CAPS All-Star cptsintl sees "Tremendous growth potential" in Baidu, arguing that: "Yes, this is the OS that will form the basic platforms for most of Asia." Meanwhile, fg14331 seeks profits closer to home, arguing: "LEDs are the coming light source with their skimpy use of power. I just installed a strip in my kitchen and it is much better than the tube light being smaller, uses much less power and the unit is smaller in comparison" -- all of which has fg144331 thinking Cree's the better tech bet.

And he's not alone. CAPS All-Star TMFZahrim, my colleague Anders Bylund, recently laid out a two-pronged bull thesis on Cree, saying it not only sells its own LED lighting, but also provides LED components to the lighting divisions at General Electric and Philips. Read more here.

Problem is, these Fools seem to be in the minority, as neither Cree nor Baidu garners more than a below-average two-star rating on CAPS. In contrast, today's top stock has had less of a run-up than Cree or Baidu, but it's got twice as many "stars" as they do. And that's just the start of our story.

The bull case for VMware
CAPS member filmgeekben believes: "Virtual computer/cloud computing is the fundamental next step in computing. All hype about 'the cloud' aside. The benefits are real, and the changes are taking place. Data and computing power is no longer tied to one piece of hardware, or even one physical location."

And according to webber05, VMware is "best-in-class when it comes to providing virtualisation solutions. Looks like the future is bright for [VMware] as more and more organisations are adopting their great technology."

And last but not least, mayahman explains why: "Even though many companies appear to be competing in the virtualization space, [VMware] is a full stack offering where virtualization is only the bottom layer. This is great because it can keep growing and outpacing it's rivals instead of letting them catch it."

Catch a rising star and put it in your pocket
But should you try to catch a ride on VMware's rising star? That's the real question.

Problem is, the answer is not entirely clear. I mean, obviously, VMware is not as expensive as it looks. Even with earnings projected to grow 19% next year, investors would have to be crazy to pay 118-times trailing earnings for the stock if that were all there was to the story. If VMware were "as expensive as it looks," the logical move would be to just buy the company that owns 81% of VMware -- EMC (NYSE: EMC) -- at 29-times earnings. Or to enter "the cloud" through a side door, purchasing major player Amazon.com (Nasdaq: AMZN) at less than half VMware's P/E, for example. Simply put, there must be a reason that investors would want to own VMware directly.

And in fact, there are two reasons. The first is that, unlike either EMC or Amazon, VMware offers a true "pure play" on cloud computing. If you believe this is the wave of the future, you probably don't want to dilute your hunch by investing in the $17 billion-worth of EMC's market cap that is not comprised of its VMware stake (and that analysts suggest will grow more slowly than VMware), or in the far-greater slice of Amazon that has nothing whatsoever to do with the cloud.

And the second reason? VMware isn't nearly as expensive as it looks. The company's cash flow statement reveals that the $205.6 million in net income reported on VMware's income statement vastly understates the firm's actual cash generation. In fact, VMware generated nearly $1 billion in free cash flow over the past year, meaning the stock sells for "only" about 25-times free cash flow.

Time to chime in
That said "not as expensive as it looks" is not the same thing as "downright cheap." Even as I discount the overvaluation argument suggested by the stock's triple-digit P/E, I also believe that 25-times free cash flow is a rich multiple to pay for a projected 21% long-term earnings grower.

So when you get right down to it, I expect that VMware will be able to hold on to the bulk of the gains its stock has racked up over the past year. But will it keep rocketing higher? No. I don't think it will.

(But if you disagree, don't be shy. Tell us why.)