Equities have continued to remain strong even as the novel coronavirus pandemic impacts growth. Expansionary monetary policies have supported stock upside coupled with a sector-based rally. As an example, the technology sector has been leading the rally since the coronavirus-driven market meltdown. But this has also lead to many overvalued stocks.
While some of these names are still investable in the grand scheme of things, there are some overvalued stocks that investors should still avoid. The overvalued stocks discussed in the column can be potential long-term value creators. However, profit-taking is likely in these names in the foreseeable future, so extreme caution is required moving forward.
Here are four overvalued stocks you should pay attention to:
Let’s take a deeper look into what makes each stock worth avoiding at current levels.
Overvalued Stocks to Avoid: JD.com (JD)
JD stock has been in a steady uptrend having delivered 113% returns in the last one year. I believe that a correction is inevitable considering the stock valuation.
JD stock currently trades at a price-to-earnings-ratio of 51x. Alibaba (NYSE:BABA), which is a close peer of JD.com currently trades at a P/E of 24x. JD.com is likely to deliver higher earnings growth in the coming years as compared to Alibaba Group. However, at the current P/E, the stock is overvalued in the near-term.
Talking about the long-term outlook, I would advise exposure to JD stock on any potential correction. For the first quarter of 2020, the company reported 20.7% top-line growth. Importantly, the company has been delivering strong operating and free cash flows. This gives the company flexibility for aggressive investment driven growth.
Another factor to like about JD.com is that the company possibly has the best logistics network in China among e-commerce players. With expansion in lower tier cities, the company stands to benefit.
Its worth noting that JD.com does not currently pay dividends. However, the company reported positive free cash flows in four of the last five years. Once dividends start flowing, the company is likely to be revalued.
Overall, JD stock rightfully belongs among the overvalued stocks you should watch out for. But that’s in the near-term. It’s still worth keeping on your investment radar.
Shopify (SHOP)
SHOP stock has witnessed a massive rally in the past year with the stock having surged by 222%. While the stock continues to trend at higher levels, a correction is likely relatively soon.
SHOP stock’s P/E of 1,642x does look very expensive. I agree that high growth companies might have insanely high P/E. However, the rally looks to be tiring.
It’s worth noting that 28 analysts have a median price target of $1,113 for the stock. Roughly, this represents a 5.5% upside from current levels. Clearly, upside might be capped from here while the downside risk is significant at current valuations.
Looking at the business, I am bullish on Shopify. The company’s subscription revenue growth has been steady. As global clients increase, I expect cash flow visibility to swell. Further, as businesses grow online, premium subscriptions will translate into higher cash flow per client.
Therefore, the business model is robust and the company is aggressively expanding globally. This provides the company with a big addressable market. Overall, SHOP stock is another name to keep in the investment radar, but also a stock to avoid for now.
Fastly (FSLY)
Technology stocks have been the leaders in the market rally after the novel coronavirus meltdown. One stock that has gone ballistic is FSLY stock. The stock has surged by 329% in the last six months and I expect profit-taking after the massive rally.
Fastly is a provider of a “programmable edge cloud platform.” With the cloud platform providing a key infrastructure support as internet consumption surges, Fastly has been attracting investors.
Last month, Bank of America downgraded FSLY stock to “Underperform” with a price target of $90. With the stock currently trading at $111, I see meaningful downside potential.
This is irrespective of the fact that the company’s top-line growth remains strong. In addition, the company has witnessed steady growth in enterprise customers.
It’s also worth mentioning that even with strong top-line growth, the company has guided for operating level losses for the current year. This is not necessarily a red flag as the company is still at an early growth stage. However, with positive free cash flows few quarters away, the company might have run ahead of fundamentals.
Etsy (ETSY)
The novel coronavirus pandemic has resulted in many sellers turning online to ensure business continuity. This has created demand for an online marketplace like Etsy that connects millions of buyers and sellers.
Its not surprising that ETSY stock has surged by 142% in the last six months. I am bullish on the business for the long-term, but I expect the stock to correct in the foreseeable future.
For Q1 2020, the company did report a healthy 34.7% growth in revenue. However, adjusted EBITDA growth was relatively muted at 10.4%. As the company grows, investors need to keep an eye on the adjusted EBITDA margin and cash flow growth potential.
Overall, ETSY stock is expensive at a P/E of 111x. I would wait for a correction and potential expansion in EBITDA before looking at the stock for long-term exposure.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modelling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector. As of this writing, he did not hold a position in any of the aforementioned securities.
