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Reality bites

28 October 2014 By Robert Cyran

Sky-high valuations are no match for the sober black-and-white of quarterly earnings. Investors knocked more than 10 percent, or well over $3 billion, off Twitter’s worth in early trade on Tuesday despite a third-quarter report on Monday that showed sales doubling from a year earlier. Blame the company’s overdone valuation. Twitter trades at more than 100 times its own “non-GAAP estimated earnings” measure. Other U.S. companies on high multiples have suffered a similar reality check.

Six companies in the S&P 500 Index with price-to-estimated earnings ratios above 35 have reported quarterly earnings so far, according to Thomson Reuters data. Five of them – Amazon, Netflix, Under Armour, Adobe and Chipotle Mexican Grill – saw their stock prices take a hit after they announced results. Only Hudson City Bancorp’s stock rose, by 1.8 percent. On average, these companies lost 6 percent of their value. Yelp is another highly valued firm whose stock took a hit after it reported earnings.

Momentum investing often works – stock prices tend to continue moving in a given direction. One explanation is that realization comes slowly to investors. It can take them multiple quarters or even years, for example, to grasp the future prospects of a company that is creating a new market or upsetting an existing one. Another possible reason is that investors themselves create momentum by chasing winners or selling losers.

Yet relying on this effect can be dangerous. The optimism built into a price-to-earnings ratio as high as that of Twitter, Netflix or Amazon is hard to maintain in the face of numbers that tell a different story. The 20 percent plunge in Netflix stock after the company’s third-quarter earnings report and Amazon’s 8 percent drop show the damage wrought by even slightly tempered expectations.

Facebook, due to report later on Tuesday, is valued at 40 times estimated earnings for the coming year. Along with other companies burdened by investors’ high hopes, the risk is that quarterly numbers might not match such a bullish story.

 

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