Growth-oriented investors love tech stocks, which outperformed many other sectors over the past few years. However, investors shouldn't chase overvalued stocks in this sector, which have high multiples that don't match their growth prospects.
Let's examine two tech stocks which are definitely overvalued, and another one which might seem pricey -- but could still be worth buying.
Overvalued stock: Ambarella
Ambarella (AMBA 2.63%) makes image processing SoCs (systems on chips) for action cameras, security cameras, dash cams, drones, and other devices. It rose to prominence as a supplier for GoPro, DJI Innovations, and Hikvision -- the world's largest makers of action cameras, drones, and security cameras, respectively.
Image source: Getty Images.
But as Ambarella grew, bigger chipmakers took notice. Qualcomm launched new Snapdragon SoCs with integrated image processors and baseband modems to compete with Ambarella in the connected camera and drone markets. Intel acquired visual processing unit (VPU) maker Movidius, which merged computer vision chips with image processing ones in its Myriad chipsets. Meanwhile, declining margins in the action camera market forced GoPro to consider using other suppliers.
This all came to a head last year, as GoPro dumped Ambarella and installed a custom chip from Japanese chipmaker Socionext in its Hero 6 camera. DJI started using Movidius' Myriad 2 VPU as a stand-alone chip in its newer portable drones, while Hikvision installed the Myriad 2 VPU in its new AI-powered security cameras.
Ambarella is trying to keep up with its own computer vision chips, but they could arrive far too late. Analysts expect these problems to cause Ambarella's revenue and earnings to fall 5% and 32%, respectively, this year. Yet its stock still trades at about 30 times forward earnings -- indicating that this former growth darling could still have room to fall.
Overvalued stock: Snap
Snap (SNAP 10.69%), the maker of the social media app Snapchat, only recently rebounded to its IPO price of $17 after spending months in the penalty box. The company's fourth-quarter earnings, which it reported in early February, revealed that its year-over-year growth in revenues, daily active users (DAUs), and average revenue per user had all accelerated from the previous quarter.
Snap's mobile app. Image source: Google Play.
Snap attributed its improved growth to its redesign of Snapchat, an improved experience for Android users, and a switch to programmatic (automated) ad buys -- which attracted more advertisers and offset lower ad prices. However, Snapchat's redesign also sparked a revolt among its longtime users, which launched an online petition to revert the changes.
Snap's non-GAAP loss also narrowed, but its GAAP loss more than doubled. It's still burning through cash, with a negative free cash flow of $197.2 million last quarter. The 187 million DAUs it reported also pale in comparison to numbers from its nemesis, Facebook's (FB 8.00%) Instagram, which topped 500 million DAUs last September.
Wall Street expects Snap's revenue to rise 61% this year and 52% next year, but the company remains in Facebook's crosshairs with no clear path toward profitability. Therefore, the stock remains extremely overvalued at a whopping 26 times sales -- which is double Facebook's P/S ratio of 13.
Not overvalued: Pegasystems
Pegasystems (PEGA +1.62%) sells software for marketing, sales, and customer service needs to a wide variety of industries. It focuses on two main areas -- CRM (customer relationship management) and BPM (business process management) solutions.
Pegasystems was founded over three decades ago, so it wasn't designed as a "cloud-first" company like CRM market leader Salesforce. In the BPM market, it faces bigger rivals like IBM and Oracle.
Image source: Getty Images.
Like many older tech companies, Pegasystems is gradually pivoting toward cloud-based services. However, the cloud service market is a highly competitive one which often crushes smaller players. Despite the competition, Pegasystems' growth looks solid, thanks to the locked-in customer base it accumulated over the years and its acquisitions of smaller players.
Pegasystems' revenue and non-GAAP earnings both rose 12% last year, and it expects 13% sales growth and 40% earnings growth this year. Pegasystems is also profitable on a GAAP basis, and it expects its GAAP earnings to rise 33% this year.
Pegasystems trades at 48 times its 2018 non-GAAP earnings estimate of $1.20. That multiple might seem high, especially after the stock's 34% rally over the past 12 months, but it's much lower than Salesforce's forward P/E of 66. Therefore, investors looking for an under-appreciated enterprise cloud play should take a closer look at Pegasystems.
