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AOL's Fall From Grace Is a Warning for Today's Tech Giants

By Travis Hoium - May 24, 2015 at 5:05PM

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Paying a high multiple for an Internet stock may be the worst investment you ever make.

AOL (NYSE: AOL) recently sold itself to Verizon for $4.4 billion, a far cry from its $164 billion valuation when it merged with Time Warner in 2000. The fall of a once dominant Internet company shows just how fast fortunes can change on the Internet.

It may also serve as a warning sign for today's tech investors, who have bid up popular names like Facebook (META 1.88%) and Twitter (TWTR 0.99%) to valuations they may have a hard time living up to. 

There's only one time the expectations for Internet stocks were higher, and that was during the tech bubble. 

Value matters
The failures of the AOL-Time Warner merger were plentiful, but I'd like to focus on just one component: valuation.

In 1999, AOL had $4.78 billion in revenue, and when the merger took place, it was valued at $164 billion. That's an incredible valuation of 34 times sales, but one that isn't that far off from some of today's biggest names in tech. You can see below that price-to-sales valuations of Internet companies today are well into the double digits, which may mean a bubble is forming.

 

Market Cap

2014 Revenue

Price/Sales

Facebook

$226 billion

$12.5 billion

18.1

Twitter

$24.0 billion

$1.40 billion

17.1

LinkedIn

$24.4 billion

$2.2 billion

11.1

Palo Alto Networks

$13.1 billion

$598.2 million

21.9

Tableau Software

$8.0 billion

$412.6 million

19.3

Source: Yahoo! Finance.

Keep in mind that AOL was highly profitable in 1999, earning $762 million, while of the companies I mentioned above, only Facebook and Tableau Software (barely) were profitable last year. These are all high-growth companies, which may make high valuations seem palatable, but the problem with high valuations has more to do with how durable their competitive advantage is than their growth rates at the moment.

Tech moves faster than anyone suspects
Every time a tech stock goes public or gets hot on the stock market, there are reasons offered why "this time is different." For example, Twitter is bringing news to millions of people in a way no one can compete with; Facebook has so much of our data that it'll be indispensable nearly forever.

The reality is that few Internet companies have any sort of durable competitive advantage. Of the sites that were widely used in the early 2000s, only Google, Amazon, and Yahoo! stand out as still being relevant, and Yahoo! is struggling to maintain that status.

The fact of the matter is that there's very little "stickiness" to Internet companies, and they can fall out of favor quickly, just like AOL did. Twitter and Facebook are already becoming unpopular with teens, who are moving on to apps like Pinterest, Snapchat, and Instagram (owned by Facebook). Users are fickle, so paying a premium for companies that may fall out of favor in just a few years is highly risky.

Internet stocks can be tempting, but the fall of a giant like AOL should be a warning for all investors. Companies can fall as fast as they rise, and if you're paying a premium for a stock, you'd better be right that it'll be the next Google, and not the next AOL, MySpace, Netscape... (the list goes on and on).

Travis Hoium owns shares of Apple and Verizon Communications. The Motley Fool recommends Amazon.com, Apple, Facebook, Google (A shares), Google (C shares), LinkedIn, Palo Alto Networks, Twitter, Verizon Communications, and Yahoo. The Motley Fool owns shares of Amazon.com, Apple, Facebook, Google (A shares), Google (C shares), LinkedIn, Twitter, and Yahoo.

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