The higher one climbs, the harder one falls. Such is the fate for stocks that are trading at ridiculously high price-to-earnings ratios. This is especially the case in the context of the ongoing market sell-off, where the S&P 500 has now declined 8.3% from all-time highs.
These three companies -- an electric vehicle (EV) maker, a videoconferencing leader, and a struggling biotech -- already have their growth potential maxed out in their stock prices, if not more. Today, let's look at why investors should be in no hurry to buy their dips.
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1. Tesla
Nowadays, many investors view Tesla (TSLA -1.01%) as a revolutionary company at the forefront of innovation in the EV industry. Its financials seem to suggest so as well. In its third-quarter update, the company said its sales increased by 45% compared with last year, to $8.7 billion.
As its revenue increased, so did its profits. Tesla's gross margin came in at 23.5% versus 18.9% in Q3 2019. And the company more than tripled its free cash flow from last year to $1.3 billion. During the quarter, it produced over 145,000 vehicles and delivered about the same amount.
The problem with Tesla lies not in its business model nor the quality of its vehicles, but in its valuation. Right now, the stock is trading for an incredible 14 times sales and 825 times earnings. Tesla's $389 billion market cap is now bigger than the world's top five automakers combined. Betting on the EV manufacturer's potential is a lucrative idea, but now is simply not the time to do it.
2. Zoom Video Communications
Zoom Video Communications (ZM 1.17%) has undoubtedly become one of the biggest beneficiaries of the coronavirus pandemic by providing an essential videoconferencing service to employees, professors, students, and pretty much everyone else. During the second quarter of its fiscal 2021, its revenue grew by 355% year over year to $663.5 million. Earnings increased more than 30-fold to $0.63 per share. There are now 370,200 businesses with at least 10 employees using Zoom's platform, 458% growth since the second quarter of 2020.
Similar to Tesla, Zoom has a huge valuation problem despite its fantastic underlying business. The stock trades for an unbelievable 113 times price-to-sales and a P/E of 661. Even tiny risk factors, such as a coronavirus vaccine bringing people back to the workplace or school and causing videoconferences to decline, could poke holes in Zoom stock's rapid growth. For those who are looking to get into tech stocks, I'd recommend ones that trade for more reasonable prices.
3. Amarin
Just a year ago, Amarin (AMRN 2.09%) was on track to become a multibillion-dollar biotech after the Food and Drug Administration approved its fish-oil pill Vascepa for reducing cardiovascular risk in patients. Last year, the drug rang up $430 million in sales, an 87% increase over 2018.
But that dream ended in a rude awakening in March, when a Nevada District Court Judge ruled U.S. patents covering Vascepa were invalid because the drug was too obvious to be considered a novel invention. In September, the company lost an appeal to the ruling.
Patents are integral to a biotech's revenue potential since they protect generic competitors from entering the market for 20 years after filing. The price of branded oral medicines typically declines by 80% within five years after losing their patent protection.
As a result, Amarin's current 8.5 P/E may appear to be very cheap based on historical financials. But the stock seems incredibly overvalued given that it could lose more than three-quarters of its revenue in a short period of time. There are already three copycat drugs on the market competing with Vascepa. Despite small-cap biotechs' high-growth potential, investing in their stocks is about as risky as it gets.
