An easy way to lose money in the market is to chase soaring stocks that don't have the growth to support their valuations. One such stock is Twilio (NYSE:TWLO), which has nearly quadrupled from its IPO price of $15 in less than two months.
Twilio's cloud platform lets developers build communication functions into their apps. For instance, it lets Facebook's (NASDAQ:FB) WhatsApp users add contacts via their phone numbers, Uber passengers call and text drivers, and Airbnb hosts call potential guests. Twilio benefits from the rise of "no stack" companies, which only develop a core service while outsourcing other features (mapping, payments, phone number lookups, etc.) to "best in breed" companies in each category.
Twilio's growth reflects that demand -- its revenue rose 70% annually to $64.5 million last quarter, while active customer accounts grew 45% to 30,780. Like many other fast-growing companies, Twilio is unprofitable, and its rising expenses indicate that it will remain deep in the red for the foreseeable future.
Why Twilio is overvalued
Twilio's revenue rose 88% in 2015, and it expects sales to climb another 52%-54% this year. At the time of writing, the stock trades at 22 times trailing sales, which is much higher than the average P/S ratio of 5 for the application software industry. But to grasp how truly frothy that ratio is, we should compare Twilio to other tech companies with comparable or superior sales growth.
Optical fiber equipment vendor Acacia Communications (NASDAQ:ACIA), which at its recent peak had rallied more than 350% from its May IPO price, trades at the time of writing at 11 times sales. Yet its revenue nearly doubled year-over-year during the first six months of 2016, handily outpacing Twilio's growth.
Momo (NASDAQ:MOMO), the "Chinese Tinder," which operates a mobile-based social networking platform in China, posted 199% sales growth last year and is expected to post 80% sales growth this year, but it still has a lower P/S ratio than Twilio, at 18. Chinese consumer finance marketplace Yirendai's (NYSE:YRD) revenue surged 556% last year and could more than double this year, yet it still trades at 8 times sales.
Twilio's sales growth and its P/S ratio clearly don't match up. If Twilio's valuation falls back in line with these companies' at about 10 times sales, its stock could be cut in half within a very short time.
Other factors to consider
Investors should also realize that Twilio's big pop was inflated by a limited number of IPO shares. By offering just 10 million shares, or about 10% of its total float, Twilio intentionally sold a limited supply of stock into a high-demand market. This caused the stock to debut with tremendous momentum, which brought in traders, automated algorithms, and investors afraid to miss out on the "next big thing."
The problem is that positive feedback loop eventually breaks down once the buying cools off. When that happens, Twilio will be a sitting duck for short-sellers looking to punish overvalued stocks. That's exactly what happened to GoPro and Shake Shack, which both went on huge post-IPO rallies before being dumped and shorted to more "reasonable" valuations. Short-sellers bet on a stock's price falling.
Another factor to consider is that Twilio can be brought down by two simple moves. First, Amazon's (NASDAQ:AMZN) AWS, the biggest cloud platform in the world, could add a Twilio-like service to its growing suite of features. Since many of Twilio's customers are already AWS customers, Amazon could win them over with cheaper bundling strategies. Second, Facebook's servers have evolved into a self-sufficient cloud platform in recent years, and it could eventually develop a Twilio-like service in house. That would cripple Twilio, since WhatsApp accounted for nearly a fifth of its revenue last year.
Patience could pay off
It might be tempting to chase Twilio at these levels, but anyone who's seen "hot IPOs" like GoPro and Shake Shack crash and burn knows better. I personally believe that Twilio is a great company that dominates a growing niche market, but I'm not willing to pay 22 times sales for that growth. Instead, I believe that the stock will run out of buyers, the short-sellers will swoop in, and the stock will fall to much more reasonable levels in the near future.
Leo Sun owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com, Facebook, and GoPro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.