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These 3 Stocks Are Absurdly Overvalued Right Now

By Herve Blandin – Updated Jul 7, 2020 at 1:20PM

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Explosive revenue growth and exposure to attractive markets doesn't turn these expensive stocks into investment opportunities.

Lockdown measures to limit the spread of COVID-19 have boosted the consumption of online services over the last several months. Many companies exposed to this trend are poised to thrive, but their stocks don't necessarily translate into investment opportunities. The market sometimes overreacts. Here are three such stocks that are overpriced right now.

1. Zscaler

Zscaler's (ZS 3.74%) cybersecurity solutions allow remote workers to safely access the internet and cloud-based resources. As work-from-home policies boosted the company's core businesses, management raised its full-year fiscal 2020 revenue outlook to a range of $422 million to $424 million, representing year-over-year growth of 39% to 40%.

Zscaler's stock price is now sitting at all-time highs, and the market values the company at an enterprise value-to-sales ratio of 36.

Green monitor displaying a financial chart with an uptrend line arrow graph overlaid on a world map.

Image source: Getty Images.

Zscaler deserves a premium given its strong performance in a cloud cybersecurity market that's positioned to grow over the long term. But that lofty valuation ignores some significant risks that could lead to disappointing results.

As the company scales up, sustaining its high revenue growth seems challenging. Despite the raised guidance, 39% to 40% revenue growth is a significant drop from last year's 59%.

Also, the competition is intensifying. For instance, tech giant Cisco Systems and cybersecurity specialist Palo Alto Networks have similar offerings. Just last week, four disruptive cybersecurity players teamed up to integrate comprehensive security solutions for remote workers.

In addition, Zscaler has yet to become profitable. Last quarter, its operating losses increased to $20.5 million compared to $13.5 million the year before, as it spent 61% of its revenue on sales and marketing expenses to fuel its growth.

2. Fastly 

Fastly's (FSLY -3.49%) stock price gained more than 600% from March lows, lifting the company's enterprise value-to-sales ratio to 40.

That phenomenal gain is partly justified by the company's exposure to the growth of internet traffic. Fastly's flexible solutions improve the availability of internet services thanks to its 72 "Points-of-Presence" (data centers) around the world.

Thanks to a boost from stay-at-home policies, management raised its full-year revenue guidance range during the last quarter. It now expects revenue to land in the range of $280 million to $290 million, up from $255 million to $265 million previously. The upward revision represents year-over-year growth of 42% at the midpoint.

In addition, the recent partnership between giant retailer Walmart and cloud platform Shopify probably excited investors, as Shopify uses Fastly's infrastructure.

Fastly's lofty valuation indicates that the market expects stunning results over the long term. Granted, Fastly proposes innovative solutions for developers. But since it requires building data centers, it remains a capital-intensive business. As a result, the company's gross margin of 56.7% during the last quarter, which held steady from last year, pales in comparison to software-as-a-service (SaaS) players that generate gross margins above 70%.

The company also has significant sales and marketing expenditures, as well as research and development costs, that are necessary to compete with giant public cloud providers, including its much larger legacy competitor Akamai Technologies. Taking these expenses into account, management expects another year of non-GAAP (adjusted) operating losses ranging from $10 million to $20 million.

3. Zoom Video Communications 

Zoom Video Communications' (ZM 0.48%) enterprise value-to-sales ratio of 88 dwarfs Zscaler's and Fastly's valuations. The video communications specialist's stock price has increased by 285% since the beginning of the year as stay-at-home policies drove users to its software. 

Investors should value Zoom at a premium. Before the coronavirus crisis, its high double-digit revenue growth was already impressive, and the company revealed phenomenal results during the last quarter.

Revenue increased to $328.2 million, up 169% year over year. The company had to use third-party cloud infrastructures to fulfill explosive demand for its video communication tools, which lowered its gross margin. Despite this, Zoom posted a profit of $27.0 million, up from $0.2 million from the prior-year quarter.

Management also raised its guidance spectacularly, forecasting full-year revenue in a range of $1.775 billion and $1.800 billion, up from a previous range of $905 million to $915 million.

ZM EV to Revenues Chart

ZM EV to Revenues data by YCharts

With such high valuation ratios, the market expects these impressive results to continue over the long term.

Yet that seems optimistic as the COVID-19 situation settles. The competition in the video communications market is also intensifying among giant deep-pocket tech companies. Microsoft, for example, has its collaboration platform Microsoft Teams, and Alphabet's Google has Meet. Also, as Zoom addresses its neglected security implementations, its easy-to-use software may lose its appeal.

Zoom's sky-high price-to-earnings (P/E) ratio of 1,540 is another sign the market overvalues the company, ignoring those risks.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Herve Blandin owns shares of Cisco Systems. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Fastly, Microsoft, Palo Alto Networks, Shopify, Zoom Video Communications, and Zscaler and recommends the following options: short August 2020 $130 calls on Zoom Video Communications, short January 2021 $115 calls on Microsoft, and long January 2021 $85 calls on Microsoft. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Zscaler Stock Quote
Zscaler
ZS
$170.51 (3.74%) $6.14
Zoom Video Communications Stock Quote
Zoom Video Communications
ZM
$73.94 (0.48%) $0.35
Fastly, Inc. Stock Quote
Fastly, Inc.
FSLY
$8.84 (-3.49%) $0.32

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

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