With the exception of investors who bought Twitter (NYSE:TWTR) at the IPO or sold the stock short, everyone else is losing money on the company. After Twitter's recent quarterly report, the stock fell by 10%, even though the results were better than expected. Non-GAAP EPS was $0.00 for the first quarter, compared to an $0.08 loss in the year-ago period. Analysts were expecting a loss of $0.03 per share. Revenue came in at $250.49 million, when analysts surveyed by Thomson Reuters were expecting $241.47 million in revenue. What gives?
What happened is that the company's monthly active users, or MAUs, increased less than what the market hoped for. The company's MAUs increased to 225 million, but the increase was only 14 million over the previous quarter and shy of the 30.9% growth the company had exhibited in the fourth quarter of 2013.
Why are MAUs so important, when the bottom line was better than expected? The answer is perception of what the future will look like.
A big portion of what the future holds for Twitter has already been discounted by the market. When future expectations were altered, Twitter got knocked down -- and continues to get knocked down for the same reason.
LinkedIn (NYSE:LNKD.DL) also fell by about 8% after its first-quarter results disappointed, but for different reasons. Supposedly, the Street was disappointed by full-year guidance from management. The Street was modeling revenue of $2.11 billion when management guided between $2.06 billion and $2.08 billion. Why should such a small miss be so destructive to the stock?
Again, the problem with LinkedIn is that there is so much baked into the stock, that a slight alteration of future guidance changes everything.
Yelp (NYSE:YELP) also been getting knocked down for a while now. Its stock has almost halved since March, when it traded slightly above $100 a share, even if the company's most recent quarterly report was also better than expected. The EPS loss of $0.04 was better than the loss of $0.06 the Street was expecting, and revenue was a little better as well. On top of that, management raised its full-year outlook.
The culprit is a little-known metric called the price-to-sales ratio
Even if revenue growth continues to be healthy compared to most stocks in the market, the key metric that investors need to pay attention to is the price-to-sales ratio. By that measure, these stocks are very rich.
A stock can have no profits and still not be expensive. For example, it may be forced to write down an asset for any number of reasons. However, when investors pay anything above five times revenue for any stock, then this stock is vulnerable to a deep correction for a variety of reasons, even if it is still performing well -- as is the case for the three stocks mentioned above.
Let's take a look back in time?
Now let's look at a chart of one of the most famous stocks of all time, and what happened to investors who bought the stock when it had similar financial metrics as the stocks mentioned above.
As the chart above shows, Microsoft (NASDAQ:MSFT) many years ago had a P/E of about 65 and a P/S ratio of almost 25. The fundamentals of Microsoft -- both on a revenue and EPS basis -- have vastly improved over the years. But because the stock was so expensive 14 years ago, investors who bought shares at the time are still losing money, even taking into consideration the dividends.
The key to avoiding getting yourself into a situation like that is to avoid buying stocks that have a very high price-to-sales ratio. All of the above stocks mentioned in the social space have very inflated P/S ratios.
While there are exceptions to this rule -- and indeed there are stocks that have proved this thesis wrong -- they are the exception and not the rule.
Yes, many of these high P/S ratio stocks in the social space and in other sectors can give you money in the short term, but that is only if you follow the market on a daily basis and are a talented trader. Other than that, buying a stock with a very rich sales multiple is a recipe for underperforming, if not losing money in the long term.
George Kesarios has no position in any stocks mentioned. The Motley Fool recommends LinkedIn, Twitter, and Yelp. The Motley Fool owns shares of LinkedIn and Microsoft. 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.