Twitter's Tumble Shows the Danger in High-Growth Stocks

Growth stocks can be enticing to investors for a lot of reasons, and successful growth stocks generate a lot of media buzz, which often fuels the popularity of companies.

But there are pitfalls to investing in high-growth stocks that investors should be aware of before wading into these tempting waters. Along with high stock valuations, growth stocks often come with high expectations, and if companies don't hit those high expectations their stocks can be punished. That's exactly what we saw with Twitter's (TWTR) 10% drop this week.

Twitter's headquarters. The long-term question for Twitter's investors is whether financial results will live up to the company's promise. Source: Aaron Durand via Twitter.

High risk in high-growth stocks
What investors are buying in high-growth stocks is the potential for a company to be a game-changing stock. We're all looking for the Microsoft of the '90s or the Apple of the 2000s, but today's high-growth companies also come with steep prices.

Two companies that have the potential to be those game changers are Twitter and Facebook (META -4.41%), which rightfully garner a lot of media attention.

The problem is, they all trade at huge multiples to sales and will have to grow at high rates for the next decade to please investors. With $801 million in revenue over the past year and a market cap of $22.2 billion, Twitter trades at a whopping 27.2 times sales. Facebook isn't much cheaper at 17.4 times sales. 

Compared to other high margin tech companies like Microsoft, Intel, or Apple, there's a lot of growth priced in. Those three companies trade at price/sales ratios of 4.0, 2.4, and 2.9 respectively. For Twitter and Facebook to grow into a price/sales ratio of 4 they have to hit high expectations for growth. Below, I've given the five and ten year compound annual growth rates required to reach that multiple. 

Keep in mind that even a price-to-sales ratio of four is high and would assume extremely high margins to justify in the long term. Plus, these assumptions haven't priced in any stock growth.

So what's the danger in high-growth stocks, and why are these multiples and growth calculations so important? Let's dig into the numbers to explain how one slip can cause growth stocks to either pop or drop.

Why growth is so risky
One common way to value a company is to estimate the value of future cash flows, which is usually what Wall Street analysts try to do by predicting growth rates and earnings per share.

There are two big levers that change valuation for a set of cash flows: the growth rate and the discount rate. Growth is easy enough to understand. If investors assume Twitter or Facebook will grow at 30%, but it grows at 20% instead, the company's value is reduced. But the discount rate we use to adjust the value of a dollar made in the future into the value of that dollar today is just as important. It's an easy way to adjust valuation for risk. So a steady company that's low-risk, like General Electric, may have a low discount rate, while a high-risk company like Facebook may have a high discount rate.

To show how growth and discount rates affect valuation, I've built a table to value a set of 10 annual cash flows over 10 years. In this model, I've assumed that you are determining the value of cash flows on day one of year one for these projected cash flows that are paid on the last day of the year. The cash flows can grow 10%, 20%, or 30%, respectively, and based on your risk tolerance, they are discounted into today's dollars at respective rates of 6%, 8%, or 10%.

Depending on the rate of projected cash flow growth and your discount rate, the amount you would pay for those cash flows can vary widely. In the table below, I've shown that they could be worth anywhere from $947 to $3,537, depending on your assumptions.

Note: Calculations are the author's.

Investors and analysts do the same thing when they're valuing companies, and it's what makes growth stocks so difficult to value. If a company misses your estimate, the perceived value could plunge; if it exceeds your estimate, it could soar.

Why growth stocks are so volatile
From quarter to quarter, the sentiment about a stock may change, and expectations could go up or down. We saw that last year when Facebook tumbled post-IPO. On the flip side, the company's recent pop was driven by strong results.

Twitter's week shows the downside risk, even after only slightly disappointing numbers. That doesn't mean it'll be a bad investment in the long term -- just that it will have to show more significant growth on the user side to move higher. That's just the nature of growth stocks, and it's what makes them so volatile.