Hype is to stocks as adrenaline is to the human body: Just as adrenaline can make us forget about pain or consequences for a brief moment -- whether it's a broken leg or a first kiss -- hype can make the market forget about a company's ills, whether it's a broken business model or overvaluation.
Why is it so bad for a company to have some hype? And what should you watch for with a company that you think is too hyped?
Good stock performance can beget good stock performance based on momentum. As a Wall Street Journal article explains: "These momentum trends in markets have more to do with the faddishness of human behavior than the fundamentals of economics and balance sheets. In essence, investors often flock to the stocks that have been going up, which tends to propel them further." This can cause a few issues.
For management whose compensation is tied to stock performance, a highflying share price might draw attention away from more important measures of performance. An increasing number of executives' pay is tied to performance as opposed to salary and options, at 50% of total compensation in 2012 versus 35% in 2009.
An additional pain for management is when the overvaluation collapses. Even if stockholders' returns on paper were unjustified, they may hold management accountable for the evaporation of the hyped-up value, calling for new leadership. To prevent this, managers might be pressured to maintain the high share price through unscrupulous manipulation of financial reports. For example, while it probably owed more to lax standards, Groupon (NASDAQ:GRPN) suffered from a few accounting setbacks. It went public with a market capitalization above $15 billion and quickly struggled to live up to that value. It then had to restate its first public earnings report, reporting lower revenue and a larger loss. Eventually CEO and founder Andrew Mason was fired at a time when the company was worth around $3 billion.
Managing the hype
A company can hide behind this hype for awhile, but the sign of a good investment is when management notes that its stock price is a distraction -- that is, when it calls out its own overvaluation. After all, when the hype inevitably wears off, the company will need to perform that much better to regain respect from the market with the near-perfect execution investors had priced into it.
Recent examples of this are Elon Musk of Tesla (NASDAQ:TSLA) and Reed Hastings of Netflix (NASDAQ:NFLX). While the historical price-to-sales ratio for the S&P 500 is about 1.4, Tesla rocks a 12.7 P/S ratio, and Netflix's P/S ratio sits at 4.8.
Musk said that Tesla's stock was overvalued in August and October, and according to CNBC, he recently noted: "I went on record saying that the price is higher than we have any right to deserve, that said, I do think that long term, the value of the company will be well in excess of that. But to give us that valuation is to have a lot of faith in our future execution."
Hastings made similar comments, according to Yahoo! Finance, saying, "Every time I read a story about Netflix is the highest appreciating stock in the S&P 500 it worries me because that was the exact headline that we used to see in 2003." In 2004, Netflix shares hit a peak around $39 per share before falling to $9 per share.
Honesty over hubris
Such honesty of management reveals a company focused on long-term success, instead of driving up the stock price with little respect for future consequences. It's also no surprise this honesty comes from companies run by their founder, who not only have a great deal of wealth tied up in their firms but also have passion and respect for their work.
The adrenaline of quick jumps in value can take their toll over time, but proper management can mitigate the consequences.
Fool contributor Dan Newman owns shares of Tesla Motors. The Motley Fool recommends and owns shares of Netflix and Tesla Motors. 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.