With the market hovering near historic highs, investors should beware of stocks that trade at frothy valuations. During market downturns, these overvalued stocks will likely fall much further than stocks trading at lower valuations.
The tech sector is filled with these landmines. Let's take a closer look at three stocks which fit that description -- BlackBerry (BBRY +1.87%), Snap (SNAP 0.47%), and Weibo (WB 0.72%).
Source: Getty.
BlackBerry
Shares of BlackBerry rallied nearly 50% this year, fueled by bullish enthusiasm for its exit from self-produced smartphones and the expansion of its software ecosystem. Unfortunately, that strategic shift still hasn't halted its double-digit revenue declines.
BlackBerry's revenue fell 37% in fiscal 2017 (which ended on Feb. 28), and is expected to drop another 32% this year. However, it posted a full-year non-GAAP profit in 2017, which ended a multi-year streak of losses as it shuttered its low-margin hardware unit and expanded its higher-margin enterprise software services.
But last quarter, its non-GAAP revenue from software and services rose just 2% annually to $169 million (69% of its top line), missing the 8% growth analysts had expected. It reported flat non-GAAP earnings growth, but it booked a slim GAAP profit -- but only due to an arbitration settlement with Qualcomm (QCOM 1.20%).
Therefore it's surprising that BlackBerry still trades at 46 times earnings, compared to the industry average of 31 for communication equipment companies. Its P/S ratio of 4.5 is also higher than the industry average of 1.8. Those high valuations make BlackBerry a risky play in a frothy market.
Snap
Snapchat maker Snap currently trades near its IPO price of $17, but I believe that it could fall much further. Its revenue jumped 286% annually to $149.7 million last quarter, but that missed estimates by $8.3 million.
Daily active users (DAUs) grew just 5% sequentially to 166 million, which also missed expectations by two million. Its average revenue per user also dipped sequentially. On the bottom line, Snap posted a whopping $2.2 billion loss, with $2 billion of that total spent on stock-based compensation.
Much of that slowdown can be attributed to Facebook's (FB 1.06%) introduction of Snapchat-like features for Instagram and Messenger. Instagram Stories notably eclipsed Snapchat, with 200 million DAUs in late April.
Snapchat's sponsored filters and ads. Source: Snap.
Unless Snap counters Facebook's tireless assault, it will struggle to meet analyst expectations for 144% sales growth this year. Missing more estimates could crater Snap's stock, which still trades at a dizzying 40 times sales -- more than six times the industry average of 6.5 for internet information providers.
Back in January, I bought shares of Chinese social networking site Weibo. But after Weibo's stunning rally in the first half of 2017, I sold the stock and bought its parent company SINA (SINA +0.00%) instead.
The reason was that Weibo's valuations got too far ahead of its stock. Weibo currently trades at 110 times earnings, compared to the industry average P/E of 38 for internet information providers. Its P/S ratio of 22 is also far above the industry average of 6.5. SINA, which owns a majority voting stake in Weibo, trades at just 27 times earnings and 6 times sales -- making it a safer play on Weibo than Weibo itself.
Weibo's mobile app. Source: Google Play.
Weibo's growth is still jaw-dropping. Its revenue rose 67% annually last quarter, its monthly active users (MAUs) grew 30% to 340 million, and it posted triple-digit bottom line growth by both non-GAAP and GAAP metrics. Wall Street expects its revenue and non-GAAP earnings to respectively rise 60% and 84% this year. However, those growth figures still can't support its nosebleed valuations yet.
The key takeaways
Warren Buffett's mentor Benjamin Graham once declared: "In the short run, the market is a voting machine; but in the long run, it is a weighing machine." For now, BlackBerry, Snap, and Weibo are all high on votes but low on weight, so investors should avoid them until their valuations cool off.
