Twitter (NASDAQ:TWTR) stock is off to a red-hot start in July, with shares of the social media company up more than 15% since July 1.
This huge rally in TWTR stock has been driven by continued recovery signs from the global advertising market, news that competing social media app TikTok may get banned in the U.S. and speculation that Twitter is on the verge of launching a new subscription service for users.
It also helps that the Nasdaq composite is up 5% in July. After all, a rising tide does tend to lift all boats.
But this rally in Twitter stock does not look sustainable.
The catalysts which have driven TWTR stock higher in July are mostly hype, and not much substance. Once the hype passes, Twitter stock will be left with significant valuation headwinds. Those valuation headwinds will drag the stock back to $30.
Here’s a deeper look.
All Hype, Not Much Substance
When it comes to the reasons why TWTR stock is up 20% in July, it looks like mostly hype and not much substance.
TikTok – the viral Chinese social media app which has quickly become the world’s hottest app amid the coronavirus pandemic – has been banned in India, and has pulled out of the Hong Kong market, mostly due to concerns with how the company handles user data.
U.S. Secretary of State Mike Pompeo also recently said that the U.S. was looking at banning the app for similar reasons. Rumors are percolating that the app may also get banned in other countries.
Of course, TikTok getting banned everywhere would act as an engagement tailwind for Twitter. All those eyeballs glued to TikTok dancing videos have to go somewhere if the app goes away.
But, given that TikTok has an American CEO with plenty of employees and offices in America, it’s still far from a sure thing that TikTok gets the boot in the U.S. Even if the app does get the boot, Facebook‘s (NASDAQ:FB) Instagram and Snap (NYSE:SNAP) are the more likely engagement winners, not Twitter.
In short, the TikTok catalyst seems overstated for TWTR stock.
So does the subscription service catalyst. Twitter may launch a subscription service over the next few years. But not to regular users. We would never pay for such a thing. Twitter has been, is and will remain free.
Instead, Twitter would launch an advanced analytics subscription service to help power users more optimally connect with their Twitter audiences. The addressable market here is pretty small. About 10% of Twitter users drive 80% of the conversation on the platform, so the power users addressable pool measures about 15 million users.
Not all will sign up for it. Even if 5 million do, at $10 per month, that’s just $600 million in revenue, which is noteworthy for Twitter, but also several years out and presently intangible.
Twitter Stock has Valuation Headwinds
The hype surrounding the TikTok and subscription service catalysts will fade over the next few weeks.
As it does, Twitter stock will be left with significant valuation headwinds.
At present, TWTR stock trades at a forward earnings multiple of 67. That’s one of the stock’s richest valuations in recent history.
Sure, you could argue that the current forward multiple is inflated by depressed 2020 earnings estimates thanks to the novel coronavirus pandemic. That’s correct. Current fiscal 2020 earnings per share estimates sit at 34 cents. Earnings are expected to essentially double in 2021.
Still, TWTR stock does not deserve a $35 price tag today.
Looking out long term, 2025 earnings per share estimates for the company sit at $1.35. I think that’s conservative. Assuming 10% revenue growth and continued margin expansion, I see 2025 earnings per share panning out around $1.60.
Based on a forward earnings multiple of 25, which is average for digital ad stocks, and a 10% annual discount rate, that equates to a 2020 price target for TWTR stock of less than $30.
Bottom Line on TWTR Stock
The red-hot rally in TWTR stock in July has been driven by hype. This hype will fade. Soon.
When it does, Twitter stock will be left staring at some significant valuation headwinds. Those headwinds will inevitably rear their ugly head.
When they do, TWTR stock looks bound to collapse back below $30.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by various other analysts and platforms, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, he was long FB and SNAP.