What Do Social-Media Earnings Tell You About Future Stock Performance?

While many retail and institutional investors own companies such as LinkedIn , Facebook , Yelp , and Trulia , there aren't many who'd argue that they're not pricey. In the past, fundamentals have been irrelevant, but if we use third-quarter earnings as a guide, this might be less true.

A repeat of history?
Back during the dotcom era, large investments were made on start-up companies with the hope of future fundamental performance. Clearly, this hope did not turn out well; and while many Internet companies faced bankruptcy, other well established companies such as Cisco and Yahoo also suffered due to the irrational exuberance and pricey acquisitions during that period.

In retrospect, the valuation of a company will always and eventually reflect its fundamentals. Yet, with Internet-based companies today, we are seeing much of the same scenario, as investors make big bets on future performance, more so than current fundamentals.

Granted, much has changed since the dotcom era, as companies such as Facebook and LinkedIn have substantial sales and a large presence. Thus, these new companies are more like Cisco and Yahoo during the Internet bubble, and could likely see a large correction at some point in time, rather than bankruptcy.

Weak performance on strong earnings
Trying to call the peak of a bubble is near impossible. Often times we will see stocks surge to levels that cannot be fundamentally explained, and these stocks will continue to soar quarter after quarter. However, among the momentum Internet-based companies to report thus far , we are beginning to see an interesting effect where stocks are not reacting to solid reports.

Trulia reported earnings on October 29, significantly beat both top and bottom line expectations with revenue growth of 117% year-over-year. Moreover, the company's guidance was above estimates, yet its stock fell 8% in the two days that followed.

LinkedIn also reported on October 29, and also beat top and bottom -line estimates. The company saw its registered users rise 39% year-over-year while total revenue increased 56%, implying that LinkedIn is better monetizing its users. Yet, shares of LinkedIn fell more than 8% after reporting the quarter.

Yelp saw stock losses of about 3% after reporting its earnings on October 30. Like other social media companies, quarterly performance was great and guidance was as well. While some of Yelp's decline might be attributed to its $250 million stock offering, investors must recall that when LinkedIn priced its offering a couple months ago, its stock actually went higher.

Facebook popped 16% in afterhours trading following its earnings, but then fell to trade near even, and ultimately rebounded to close with gains of 2% in a very volatile session. Yet, over the last week, Facebook has traded lower by 5%, which is consistent with its peers.

With that said, Facebook's earnings were simply incredible: The company easily beat third quarter estimates and posted revenue growth of 60% year over year. In addition, expenses rose just 45%, showing a decline from previous quarters, and mobile revenue growth saw quarter-over-quarter gains of 34% after seeing 75% growth in the second quarter. Hence, investors were clearly fickle despite this impressive quarter.

When valuation comes into question
So, given the impressive year-over-year growth of these four companies, why is it that post-earnings performance was so mediocre? Perhaps, we are reaching a point where this level of growth is already priced into the stocks. At some point, the number of investors willing to pay 20 times sales begins to drop, and with market capitalizations so high, it is possible that we are seeing this technical shift.

The Internet content & information industry (within technology sector) trades at 7.1 times sales, which is a large premium to the S&P 500 at 1.55 times sales. Here is how these four noted companies trade relative to trailing 12 month sales:

As you can see, these companies all trade at large premiums compared to the industry, and much larger premiums to the S&P 500. In retrospect, the reason this industry has such a large premium is because of these companies and their peers. Given this fact, the strong performance of earnings, and the poor or fickle post-earnings performance, we might now be approaching peek valuation levels. As a result, these high-flyers might no longer be the great investments they once were.

Final Thoughts
Eventually, whether it be now, next month, or in two years, these Internet-based momentum stocks will align with fundamentals. It can happen with a one-year colossal collapse like we saw with Netflix. Or, as these companies continue to grow, we may see several years of no or limited stock performance, which we saw with Google in the five years prior to 2012. Either way, valuation realignments always occur for momentum stocks.

Now, the good news is that as earnings continue to grow, and if stocks either decline or trade flat, valuations become more attractive. Hence, it doesn't take long for companies growing at 30%-50% long-term to cut these high premiums in half. At that point, these stocks might once more be a buy, but until then, I'd use high valuations and a lack of post-earnings performance as a sign that days of market-leading short-term gains might be limited for this group.

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The article What Do Social-Media Earnings Tell You About Future Stock Performance? originally appeared on Fool.com.

Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Facebook and LinkedIn. The Motley Fool owns shares of Facebook and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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