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Is This the Riskiest Tech Stock on the Market?

By Jamal Carnette, CFA - Dec 26, 2017 at 12:33PM

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This trendy stock's return doesn't justify the risk. All investors, particularly beginners, should avoid this name.

Investors are often on the look for the next big thing. Financial analysts spend countless hours poring over research to identify trends to find that diamond in the rough. For mom-and-pop investors, however, a better way to spend that time is to identify poor investments.

As fund manager and finance academic Eric Falkenstein notes, "In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves."

Earlier this year, Snap Inc. (SNAP -5.37%), parent company of Snapchat, debuted in the public markets. And while the stock hits all the investor-friendly buzzwords (social-media, demographic tailwinds, augmented reality, among others), investors would be well-suited to stay away from the stock as the potential reward isn't worth the risk, at least at this point.

A blye street sign that says risk ahead.

Image source: Getty Images.

Snap's valuation is insane

Most investors can forgive Snap for reporting losses. Many new companies report losses as they scale to capture market share. Two years after Twitter's (TWTR -8.18%) IPO, the company is still reporting net losses (GAAP compliant). Additionally, Snap's losses were exacerbated by an inventory charge from unsold Spectacles, which should ameliorate in the upcoming quarters.

What's concerning is Snap's trading at 25 times trailing-12-month sales, a rich valuation that's never been afforded to Facebook and only shortly for Twitter. For a comparison, the greater S&P 500 historically trades in a range between 1 and 2.5 times sales.

TWTR PS Ratio (TTM) Chart

TWTR PS Ratio (TTM) data by YCharts

Even still, I'm willing to forgive the non-existent earnings and the astronomical price-to-sales valuation. First, it's better for investors to pay attention to cash generation rather than earnings as studies have confirmed it is cash flow that is a better predictor of future stock performance. And with technology companies, these two figures often diverge as many companies issue stock as inducement to employees, a figure that effects earnings but not cash flow, as it's not an expense.

However, cash flow is even more foreboding for Snap. The company is reporting negative operating cash flow over the prior 12 months, meaning the company is burning through cash to maintain the business. At this point, Snap has not demonstrated it can be successful at unit economics. Snap's current situation is reminiscent of the classic finance joke, "We lose money on every sale, but we'll make it up on volume."

Young investors, don't make this mistake

Snap's the perfect example for the maxim, "A good product doesn't mean a good investment." And here's where I get concerned. It's almost as if the stock is the market's perfect trap for naive, first-time investors. There's nothing wrong with the company's product, but I don't see the stock quickly being able to reverse its poor performance.

As of this writing, shares of Snap trade at $16 per share, below its IPO price of $17 per share and 50% below its first-day closing price. Note this includes the sky-high expectations baked into its valuation. It's almost as if the stock is the market's perfect trap for naive, first-time investors.

It's possible Snap will be a strong-performing stock, and I applaud founder Evan Spiegel for creating a business of nearly 2,000 employees, but it came to the market too soon. In the short run, this company has too much risk to invest in and mom-and-pop investors are better off not subsidizing this company's attempts to transition to a publicly owned company.

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Stocks Mentioned

Snap Inc. Stock Quote
Snap Inc.
$23.42 (-5.37%) $-1.33
Meta Platforms, Inc. Stock Quote
Meta Platforms, Inc.
$200.04 (0.71%) $1.42
Twitter, Inc. Stock Quote
Twitter, Inc.
$37.39 (-8.18%) $-3.33

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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