In December 2020, Pascal Blanque, chief investment officer at asset manager Amundi, opined that the tech stocks boom is a “bubble waiting to burst.” Blanque added that it’s difficult to “justify the current valuations.”
I believe that the entire technology pack is not overvalued. There are attractive investments even at current levels. However, there are some tech stocks that are expensive and can be avoided. I am also of the view that the broad markets can correct in the foreseeable future. After a big rally, a 10% correction is likely. It therefore makes sense to avoid high beta stocks and overvalued tech stocks.
Before I talk about three overvalued tech stocks, I must add that I remain bullish on equities for fiscal year 2021. The outlook for the year was been summed-up well by Wharton finance professor Jeremy Siegel. He opines that “home equity is now strong, portfolios are strong, liquidity is strong, and 2021 looks strong. I definitely see next year as being a good year.”
With this overview, let’s discuss three tech stocks that are overvalued and can be avoided. Of course, these companies have a sound business model, but valuations are beyond fundamentals. They are:
Overvalued Tech Stocks: Zoom Video Communications (ZM)
At a forward price-to-earnings-ratio of 126.3, ZM stock is certainly among the overvalued tech stocks. Even after some correction in the recent past, ZM stock is higher by 435% in the last year. I would avoid the stock at a time when the broad markets look overheated.
I do agree that Zoom Video is likely to see strong earnings growth in the coming years. Analyst estimates point to annual earnings growth of 25% over the next five years. However, the stock is still trading at a price-earnings-to-growth ratio of 5.0, which is expensive.
Another important point to note is that the Covid-19 pandemic accelerated the adoption of Zoom Video across organizations. This translated into a revenue and earnings bump-up. It remains to be seen if the company’s earnings growth remains attractive if mass vaccinations prove to be effective.
In terms of positives, Zoom Video reported free cash flow of $388 million for the third quarter of 2020. This implies an annualized FCF of $1.2 billion. If growth sustains, the company is on track to deliver FCF in excess of $1.5 billion this year. ZM stock is worth keeping on the radar. However, it’s too risky to consider fresh positions at current levels.
Cloudflare (NET)
Click to Enlarge
NET stock is another overvalued name among tech stocks that should be avoided. NET stock surged by 335% in the last year and looks expensive at a market capitalization of $22.9 billion.
My reason is as follows. For FY2019, Cloudflare reported an operating loss of $71.2 million. Operation loss for Q3 2020 was $4.5 million. It’s very likely that the company will achieve profitability at in the next quarter. However, at $22.9 million market capitalization, the stock is expensive. The company just started to generate positive operating cash flows.
In the long term, Cloudflare expects its operating margin to expand to 20% as sales, marketing and administrative expenses decline. I am also positive on the company’s cloud platform. Cloudflare expands presence in terms of customer acquisition and global reach. However, a good business is not always a good investment.
To back my view, 15 analysts offering 12-month price forecasts for NET stock have a median price target of $75. The stock currently trades around $79. Therefore, a healthy market correction can result in a sharp downside.
Overall, NET stock is another name worth keeping on the radar. However, the stock is unattractive from a valuation perspective.
Shopify (SHOP)
SHOP stock is another name that surged in the last year and looks expensive at current levels. The stock currently trades at a P/E ratio of about 310. Even if we consider the future earnings growth potential, SHOP stock is overvalued.
It’s always good to look at the broad analyst consensus. A 12-month price forecast for SHOP stock offered by 28 analysts indicates a median price target of $1,150. This would imply a 4.3% upside from current levels. It therefore makes sense to avoid the stock.
I want to add here that the stock has a beta of 1.63. This is another reason to avoid the stock. I remain bullish on equities as an asset class for the current year. However, I would not be surprised if there is a 10% to 15% correction from current levels. Given this view, it’s a good time to go overweight on low beta stocks.
From a business perspective, the company’s merchant and subscription solution revenue has been trending higher. With the novel coronavirus pandemic accelerating the growth of e-commerce, the positive trend is likely to sustain. As recurring revenue grows (Shopify Plus), the company is well positioned to generate incremental cash flows in the coming years. Further, with global presence, the company has a large addressable market.
SHOP stock is therefore another name among tech stocks that’s worth keeping on the radar. However, it’s unattractive as an investment at current valuations.
On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
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.
