My New Formula Says These Are the 5 Most Overvalued Stocks

Who said that the Fool's own Morgan Housel was the only one who got to make up indexes? A few months ago, Morgan created his own index by looking at a company's "price to CEO's ego divided by lobbying activity as a percentage of revenue." OK, so it was clearly a farce, but today it's my turn to create an index.

My very own index
Making things up as you go along isn't a science, so the only thing I ask is that you not treat it like one. What I set out to do was, through four separate metrics, determine what the five most expensive stocks were. The metrics I chose were simple: price/book, price/sales, profitable on a 12-month trailing basis, and price/cash flow. I then set up the following parameters and excluded biotechnology stocks, as I wanted companies with semi-consistent revenue streams, and oil and natural gas trusts, because they have nominal book valuations. In short, I wanted tangible evidence that would allow me to justify a company as overvalued.

Here's a closer look at my starting parameters:

• Price/book > or = 10.
• Price/sales > or = 10.
• Profitable on a trailing 12-month basis.
• Price/cash flow will be used as the deciding factor.

Using The Motley Fool's CAPS Screener, I had narrowed more than 5,000 companies down to just 24 with the parameters above. After removing biotech and oil and gas trusts from contention, I was left with just nine.

The last step here is pretty simple: Add the values of these metrics (P/E excluded) together. The higher the number, the more overvalued the stock. I give you the world premiere of the "TMFUltraLong Overvaluation Index" (and yes -- I'm rushing to the patent office right now to lay claim to my trademark).

Source: Motley Fool CAPS Screener; Morningstar; author's calculations. Data as of market close March 30, 2012. Please note trademark is fictitious, but I'm having a moment here, so let me enjoy it.

Tech you very much!
One thing you'll notice about this list above is that it's very tech-centric. You will pay a steeper price for faster growth in the tech sector, but I'm not sure if anyone should be paying these prices. Let's take a closer look at the five worst offenders.

Mitek Systems, far and away the most expensive company according to my handy-dandy formula, is one of the software companies behind the mobile deposit and mobile bill-pay revolution. While mobile bill-pay is expected to take off in the coming years, Mitek's valuation has already lifted off well in advance of actual results. In fact, Mitek has yet to produce much more than $1 million in free cash flow over the past 10 years. With its share count more than doubling since 2002 and sales remaining stagnant as the company's business direction has wavered, Mitek definitely looks like a top candidate for the market's most overvalued company.

Baidu is a company I spoke out against in November despite its being one of the darlings of Wall Street. Baidu, which controls about 70% of the search engine market in China, has been a longtime Motley Fool Rule Breakers selection that has not disappointed investors. However, with the prospect of China's growth slowing in the cards and increased competition from the likes of Sohu.com on the horizon, maintaining Baidu's torrid growth pace just doesn't seem reasonable. Considering all three metrics that go into the TMFULOI formula, I'd say Baidu represents the most consistently overvalued stock.

What can I say about LinkedIn that I haven't already said about the company in negative light? LinkedIn has grown its revenue by more than 100% for six consecutive quarters, but only recently became solidly profitable. The concern with LinkedIn is that its business is strongly tied to the health of the economy. I feel its strongest aspect lies with premium subscriptions, which currently only account for 20% of total revenue. With unemployment levels still above 8%, LinkedIn could find itself easily susceptible to a sales shortfall. Huge expectations are built into its stock price at these levels, and any foul-up will be severely punished.

Also in the top five is Yandex, Russia's most dominant search engine with 60.8% of market share. The company's fiscal 2011 report highlighted growth similar to Baidu -- 60% revenue growth on the heels of a 51% spike in net income. What the report also did well was mask the fact that traffic acquisition costs are going through the roof. For all of 2011, total TAC rose by a staggering 91%, dwarfing the rise in sales. Costs as a percentage of revenue rose 280 basis points to 23.5% in 2011. This is simply a numbers game, and if the costs associated with acquiring new customers keeps rising, or even stays where it is now, Yandex is never going to be able to catch up with its current valuation.

Rounding out the top five overvalued companies is the eBay of Latin America, MercadoLibre. Like all the others, MercadoLibre is growing like a weed, but it's hiding some potential flaws underneath those torrid growth rates. For one, due to payment volume growth outpacing merchandise volume growth, its gross margin has fallen each year since 2008. This simply means it's making less with each dollar it uses. And like the others on this list, I'm worried about MercadoLibre's rapid increase in expenses. The company's total operating expenses rose 33% last year after rising by less than 20% in 2010. If it can't keep its expenses under control, then its falling margin rate could become a concern.

Foolish roundup
While I'd hardly call myself the next Robert Shiller, my simplistic index seems to have led me to two possible conclusions. First, the tech sector does indeed offer the biggest risk-versus-reward ratio within the market. Secondly, it leads me to believe that much of the technology sector, specifically cloud, Internet, and social media-based platforms, are grossly overvalued and probably due for a major correction. If these five companies aren't already listed as underperform in my CAPS account, I definitely plan to make a CAPScall of underperform on each of these five tech heavyweights.

What do you think of my groundbreaking new formula? Tell me about it in the comments section below.

If you're not into making things up as you go along, then the Motley Fool's latest special report, which highlights our chief investment officer's "Top Stock for 2012," might be right up your alley. Find out for free which stock has him buzzing with excitement.