While some have been claiming that the stock market as a whole is in a bubble, I tend to agree with Warren Buffett's comment that the stock market is currently in "a zone of reasonableness." There are, however, certain individual stocks that have clearly been in a bubble for quite some time, and it seems like at least a few of these bubbles are starting to burst. Electric car maker Tesla (NASDAQ:TSLA), Internet company Yelp (NYSE:YELP), and social media behemoth Facebook (NASDAQ:FB) are a few examples.
An inevitable collapse
It's funny how the sentiment surrounding Tesla has changed since its stock began its current collapse. The endless talk of the genius of CEO Elon Musk seems to be far less prevalent today than it was a few months ago. Tesla was supposed to be the next big thing, yet the stock is down 35% in less than two months.
The answer is simple -- the future baked into the near-$200 share price simply wasn't possible. Tesla was being valued at about $1 million per car per year at one point, which doesn't make sense. In September, I warned about the irrational exuberance surrounding Tesla, and it seems that reality has finally caught up with the stock.
What finally caused the stock to collapse? It wasn't the recent fires involving the Model S, or the issues with securing adequate lithium-ion batteries, or even the rumors of a possible recall. These are excuses for people to sell, but they're not the real reason behind it. The real reason for the sell off was a simple case of irrational optimism giving way to more realistic expectations. Those not caught up in the euphoria of the electric car saw it coming from a mile away.
This says nothing about Tesla as a company, only Tesla as a stock. Tesla may go on to be extremely successful, but paying a price that assumes this success already occurred has clearly ended badly.
A challenging business model
At its 52-week high, Yelp was valued at a staggering 24 times TTM sales. However, Yelp has no earnings. In fact, as expenses have been rising as fast as revenue. Yelp provides reviews of local businesses and allows registered members to add to its enormous database, but the company makes its money by selling advertising.
This business model introduces a potential conflict of interest. Some businesses have accused Yelp of filtering out good reviews for companies that don't advertise with Yelp, putting them at a disadvantage. Yelp uses an algorithm to highlight what it calls "useful" reviews, which actually hides some from the main page.
Yelp's CEO has denied these claims, most recently during a Reddit Ask Me Anything, but this highlights the difficulty of Yelp's business model. Only businesses with high ratings will want to advertise with Yelp. A business with a low rating would essentially be advertising its low rating.
Shares of Yelp have begun to collapse, down about 16% from the 52-week high. Like Tesla, Yelp the stock and Yelp the company diverged, and now reality is forcing them back together.
After fully recovering from its post-IPO slump, shares of Facebook began to sell off in October. Down 15% from its high, the shares still trade at more than 16 times TTM sales. The bull case for Facebook is simple -- the company has over one billion users and is working to revolutionize online advertising. But there is a big problem with Facebook's business model.
Facebook requires an enormous user base, and its size implies that there are meaningful switching costs for users. But, that doesn't stop users from trying related services. Last year, Facebook bought Instagram, a photo-sharing app with no revenue whatsoever, for about $1 billion, and the company recently offered $3 billion to buy Snapchat, another photo-sharing app with zero revenue. Facebook's offer was turned down, but an acquisition could happen down the road.
This situation exemplifies the problem. In order to protect its business, Facebook can't sit idly by as start-up apps claim hundreds of millions of users. Facebook must buy those companies, and given the crazy valuations tech companies are getting these days, Facebook ends up paying billions of dollars for zero revenue. Then, the next big app comes along, and Facebook needs to buy that too.
The bottom line
There are plenty of stocks propelled solely by hype, and the aforementioned three look like they're finally coming back to reality. One common indicator of a bubble stock is the price-to-sales ratio -- if it's not in the single digits, it's probably best to stay away. All bubbles eventually pop. It's not a matter of if, but when.