Twitter and LinkedIn Fall Off the Expectations Treadmill

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Stock prices continued their seesaw movements for the week, with the benchmark S&P 500 index, and the narrower Dow Jones Industrial Average (^DJI -1.66%), both rebounding 1.2% on Thursday. Whether the broad market will ultimately suffer a 10% correction remains an open question; however, two high-profile social networking stocks, Twitter (TWTR) and LinkedIn (LNKD.DL) -- both of which smashed the market last year -- have been handed a swift comeuppance for delivering an outlook for 2014 that fell short of investors' expectations.

Twitter, which reported its first set of quarterly results after Wednesday's market close, witnessed its shares lose almost a quarter of their value today, to close at $50.03 – in line with analysts' $50 median price target just prior to the earnings release.

Not that one ought to place much weight on the price target's absolute level, but, as I remarked this morning: "Following a huge post-IPO run-up, a stream of analysts had begun to downgrade the shares on concerns about valuation... When analysts -- who are predisposed toward a cheery outlook -- turn bearish on a stock, it is past time for investors to revisit their bullish assumptions." In this case, investors were forced to mark down their assumptions regarding Twitter's user growth.

For investors who think today's bloodletting represents a buying opportunity, I'll simply note that the overvaluation of Twitter shares was sufficiently extreme that I'm not at all convinced that today's decline has eliminated it. With an enterprise value equal to 22 times next 12 months' revenue estimate, it's far from obvious that the shares offer much value at $50. (For reference, the equivalent multiple for Facebook is 13 times.)

And speaking of overvaluation... Shares of LinkedIn rose nearly 90% in 2013, and they didn't look cheap going into this afternoon's fourth-quarter earnings release, at 115 times next 12 months' earnings-per-share estimate. Given the enormous growth expectations that are embedded in that number, the share price is naturally very sensitive to information that would cause investors to recalibrate those expectations.

Unfortunately, while LinkedIn did beat Wall Street's expectations for fourth-quarter revenues and earnings per share, the company fell short of consensus estimates for 2014 revenues and EBTIDA (earnings before interest, taxes, depreciation and amortization – a measure of cash flow):

Source: LinkedIn, S&P Capital IQ

As a result, the stock was down 8% in after-hours trading, and we can probably expect a similar decline during tomorrow's session. That loss is substantially less than the one Twitter suffered, but then LinkedIn's shares were less overvalued to begin with.

Beyond that, LinkedIn's business continues to perform: Fourth-quarter revenues for Talent Solutions, the company's largest segment, grew 53% year on year – the highest growth rate among its three segments. (However, at 36% and 48%, respectively, growth in Marketing Solutions and Premium Subscriptions wasn't exactly shabby.)

In addition, the company announced its largest acquisition to date, that of Bright, a job-matching technology firm, in a transaction valued at approximately $120 million. This looks like a technology and engineering talent acquisition that is entirely consistent with LinkedIn's core activity.

If you own the shares, don't be put off by a drop in their price tomorrow – LinkedIn's long-term prospects continue to look bright. However, you ought to be aware that, given their current valuation, a long-term orientation is essential to being a LinkedIn shareholder. It will take time for the company to justify that valuation; in the meantime, shifting sentiment could produce a volatile journey.