Web-based real estate firm Zillow (NASDAQ:ZG) is the fastest growing real estate web company on the planet, and has been simply blowing results out of the park. Analysts are on the stock like wildfire, and revenues are set to climb more than 50% in the coming year. On a macro level, the housing rebound can only spell more tailwinds for the trendy tech company. If Zillow were a five-bedroom home in Malibu, where mansions sell in the tens of millions, it would sell for billions. At 70 times forward earnings, this company is well-managed, growing fast, and outrageously, nonsensically overvalued.
The definition of insanity
Remember when (insert tech firm here) traded at more than 50 times earnings and was growing unbelievably? You would be a fool not to buy such a monster stock. Fast forward a couple of years from any one of the numerous times this has happened, and you have a bunch of sad investors who had their lunch eaten before their very eyes.
In no way do I find Zillow to be a bad company. In 2011, the company did more than $7 million in free cash flow -- great for a young tech firm. In 2012, it delivered just under $20 million, though in the first quarter, there was no FCF due to high spending. For 2013, cash flow can grow even more. The company has zero long-term debt. It provides a great product that addresses the needs of today's real estate shopper. This past quarter, Zillow delivered record quarterly and all-time high traffic numbers.
Now, let's say the company is touched by the beard of Zeus, and generates $100 million in free cash flow this year. At today's price, that would mean you're paying 20 times that cash flow. It's within the realm of reason that it could achieve such a figure in a couple of years, but then you run the risk of macroeconomic meltdown, a reversal or softening in the U.S. housing market, and technological disruption.
For a bit of context, competitor Trulia (UNKNOWN:TRLA.DL) is in negotiations to buy Market Leader (UNKNOWN:LEDR.DL) for $355 million. Market Leader is a smaller (and growing) business that's similar to both Zillow and Trulia. Since Market Leader is still earnings negative, we can't compare it on a P/FCF basis, but we can look at other metrics. For one, Market Leader trades at a still-ridiculous-but-slightly less-so 57.2 times forward earnings. It trades at 6.4 times last year's sales. Zillow trades at 16.4 times last year's sales. Management expects sales to hit (on the high end) $182 million -- that implies a price of 10.55 times forward sales. If they double a year or two after, which would be unbelievably phenomenal, it would trade at 5.3 times sales.
If you have faith that the housing market will interminably rise as it's never once done, and that people will buy homes like they buy iPhones -- then you should probably invest in the stock.
Shares fell after its earnings release disappointed investors with too much spending. The spending, long-term, is not the issue investors should fret over. The company needs to compete with Trulia, and it's a game of scale at the moment.
Let's say I own a lemonade stand that is on top of Runner's Peak and is a complete monopoly. Last year it earned $1,000 after expenses and, this year, with this crazy health craze, it's set to earn $8,000 (and even more after). Would you pay over $500,000 for it? If yes, call me.
Fool contributor Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends Zillow. The Motley Fool owns shares of Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.