Priced for Perfection Is a Lie

Shares of Baidu (Nasdaq: BIDU  ) rallied last week, landing shares of China's leading search engine within spitting distance of an all-time high.

It wasn't a stellar earnings report or the improving prospects of Internet usage within the world's most populous nation that have propelled the stock nearly 10% higher over the past four trading days. It's actually buzz over last week's launch of a new app-based platform that's making investors tingly.

Baidu is teaming up with developers -- 400 apps and counting -- to launch Web applications without having to leave Baidu's site. In exchange for hosting the app and providing some welcome exposure, Baidu is taking a 30% slice of the resulting revenue.

This can be meaty, naturally. Baidu already serves up roughly two-thirds of the search queries in China, so it's already the portal of choice. If it excels as an app marketplace, it can derive a healthy revenue stream that would be incremental to its flagship paid search business.

If bulls didn't see this coming, you can be sure that bears didn't see the catalyst either. A stock that has already had a monstrous run -- up better than eightfold since bottoming out less than two years ago -- may not be done after all.

Let's go Mythbusters on "priced for perfection"
The three funniest words you will ever hear in investing are "priced for perfection." Analysts, talking heads, financial bloggers, and message-board pundits will toss out the expression when a stock is seemingly trading at its ceiling.

Lofty valuations seem to leave little hope for upside -- even though facts, analyst estimates, and competitive climates are always in a state of flux.

If I can offer up a wee bit of homework -- fun homework -- think of a stock that appears to be fundamentally overvalued as it trades near its all-time high. Now go ahead and Google the stock along with the term "priced for perfection" in quotes. You will be surprised at how that tag was hurled about -- at much lower price points.

It's happening with Baidu. I wrote about a Canaccord Adams analyst that set a split-adjusted price target of $32.40 on the shares two years ago. The stock has gone on to nearly triple.

At the time, no one figured that the Chinese Web economy would continue its fierce cyberspace migration or that Google (Nasdaq: GOOG  ) would engage in a partial retreat earlier this year.

The fatal flaw of "priced for perfection" is that it's based on expectations as they stand now. Investors who know how to choose well -- like I did when I recommended Baidu to Rule Breakers newsletter subscribers at a tenth of today's price -- will find that their best stocks climb a wall of "priced for perfection" with destiny-altering aplomb.

More than Baidu
It's not just Baidu. Apple (Nasdaq: AAPL  ) is a serial debunker. First, it was a cap on its premium computing niche. Then we find analysts pegging the market potential for its portable media iPod juggernaut.

Every time that the pros think they have a read on Apple's upside, out comes the iPhone, an iPad, and potentially now even the new and improved Apple TV.

I was all over the misuse of "priced for perfection" on Apple three years ago, going all the way back to a Prudential analyst in 2004 that used those same three words when the stock appreciated past its now split-adjusted price target of $13.50.

It's OK to laugh.

This happens all the time. Here are a few stocks that may seem overvalued today, with a few thoughts on what the cynics have been missing on the way up -- and may continue to miss on the way out.

  • Netflix (Nasdaq: NFLX  ) : Shares of the flick flinger hit a new intraday high of $142.50 on Friday. Bears figuring that DVD and Blu-ray rentals would have a limited shelf life as a business model may have been on the mark, but they completely underestimated Netflix's ability to lead the premium digital subscription market. Nearly 10 million of its 15 million subscribers are now streaming movies and shows from Netflix's growing digital library. Skeptics who now fear that digital heavyweights will crash the party are forgetting about the limitations of digital delivery -- and that Netflix is the only cash-rich company that is built to serve the customer on both fronts.
  • Sirius XM Radio (Nasdaq: SIRI  ) : When the satellite-radio provider bottomed out at $0.05 a share last year, most investors left it for dead. The last-minute sugar daddy arrival turned heads, but naysayers still felt the model wasn't financially feasible. Well, the stock has become a 20-bagger since then, cranking out breakeven results in each of its past four quarters. Ceiling watchers may not realize retention and conversion rates are improving, regardless of tough year-over-year comparisons in the auto market. The three-year freeze on rates also ends next year.
  • Green Mountain Coffee Roasters (Nasdaq: GMCR  ) : The company behind the Keurig single-cup brewers and most of the refills that fuel the caffeinated sips has always felt overvalued on an earnings basis. Distribution-widening deals and a perpetually growing installed base of K-cup brewers keep leaving analysts with little choice but to revise their targets higher. Party poopers on decaf probably don't realize that forward guesstimates continue to inch higher. Over the past three months alone, analysts have gone from expecting $1 a share in earnings for the fiscal year that begins next month to $1.18 a share.
  • lululemon athletica (Nasdaq: LULU  ) : In the realm of retail stocks, sales- and earnings-based valuations will pit this high-end yoga apparel retailer at the priciest end of the fundamentals range. However, the chain is still in its infancy with plenty of expansion room to work through. Net sales soared 69% this past quarter, with earnings tripling along the way. Critics miss the expansion potential outside of Canada and the United States, the obvious benefits of being a brand tastemaker in an improving economy, and the possibilities to parlay its brand into other upscale ventures. 

You can bet that your next Google expedition will find these stocks tagged as "priced for perfection" at significantly lower price points than today.

What good is being "priced for perfection" today, when predicting the future is anything but perfect?

Do you own any stocks that have been unfairly tagged as overvalued? Share your thoughts in the comment box below.

Google is a Motley Fool Inside Value pick. Baidu, Green Mountain Coffee Roasters, and Google are Motley Fool Rule Breakers recommendations. Apple and Netflix are Motley Fool Stock Advisor selections. The Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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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.

  • Report this Comment On September 07, 2010, at 10:30 AM, refriedbean wrote:

    Green Mountain's mountain is truly green.

  • Report this Comment On September 07, 2010, at 12:17 PM, tom2727 wrote:

    Priced for perfection is a lie... Except when it isn't. I'm sure there were articles using exactly those words when talking about stocks like KKD, CROX, JDSU, and dozens more. Turns out they were right. And even with your SIRI example back in 2000 (60 bagger in reverse to today's price).

    So it seems like buying a portfolio of "priced for perfection" stocks may not be such a great idea.

    I think what you mean to say with this article is that it's OK to buy a stock trading near all time highs if you believe the fundamentals are going to drive the stock even higher. And possibly you mean to say that your average WS analyst is correct about as often as a stopped clock. Won't get an argument from me on those points.

  • Report this Comment On September 08, 2010, at 10:35 PM, Mstinterestinman wrote:

    The point is if a company has a premium valuation but is truly great the righ time to sell is almost never. Unless the fundamentals change. Imo if more people based valuation off of the PEG ratio alot less companies would be called overvalued.

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