Twitter: A Perfect Example of How Not to Invest

Twitter: A Perfect Example of How Not to Invest

For too many investors today, it seems investment decisions are based on intangibles: Do they like the product or service? Do they use whatever it is the company offers? Will the stock jump in the next week, month, or quarter? None of these address what should be foremost in the minds of investors: What about the company's fundamentals?

Twitter's recent share-price spike is only one of many examples demonstrating the change in what investors find important. It just happens to be the most ridiculous.

Even , with its current price-to-earnings ratio north of 1,400 and forward P/E of 151, makes more sense than Twitter. You could possibly rationalize Amazon's high valuation by the recurring costs associated with building out its distribution centers and the long-term upside that offers. No such explanation exists for Twitter's valuation.

One of many concerns
Twitter has about 545 million shares outstanding. With its current stock price around $68 per share, the market is valuing Twitter at $37.1 billion. But of all those shares, a mere 11% make up Twitter's float, or the number of shares that are available for trading on a daily basis. This equates to a mere 60 million shares of Twitter stock potentially up for grabs on a given day -- and that's a problem.

Why should investor's care about Twitter's float? As an analyst at Wunderlich Securities put it, the small number of available shares creates "a significant leveraging effect on the market value of the company." In other words 11% -- or about $4.2 billion of investors' money -- is responsible for Twitter's $38 billion valuation.

Twitter's small float, combined with Thursday's sky-high trading activity of nearly 83 million shares, raises another red flag. On Dec. 26 alone, there were more Twitter shares traded than were available with its meager float, meaning its stock price is being driven by day-trading types. Day traders aren't concerned with stable, long-term companies; they couldn't care less where a company will be five or 10 years down the road. If there is a point (or a fraction of a point) to be made on a stock, a day trader's happy. And it appears Twitter is making a lot of short-term investors ecstatic.

A storm is brewing
Twitter's tiny float owes partly to early investors and shareholders signing agreements to hold on to their stock for a set period of time so as not to saturate the marketplace. Such lock-up agreements are fairly common -- but so is a big impact when the lock-up periods expire.

When Twitter's 180-day lock-ups expire, which will be in early May of 2014, any insider selling will put pressure on its stock price, particularly if it stays even close to current levels. But even that is short-term thinking and fails to answer the fundamental question Twitter shareholders seem comfortable avoiding: How long, if ever, will it take Twitter to generate the earnings needed to justify its ridiculous share price?

Final Foolish thoughts
Let's hope Twitter doesn't become the poster child of the next generation of investors. There was a time when a company needed to demonstrate a fundamental basis for its stock price or, at the least, share a concise plan of action on how it intended to achieve improved revenue, earnings, cash flow, and the like.

But if Twitter is any indication, financials are taking a back seat to how much an individual investor knows and likes a product, and that's a recipe for long-term disaster. I don't know how to make chips for a laptop or set up cloud data centers, but I do know Intel is a solid long-term buy. On the other hand, tweets are quaint and easy but offer no fundamental reason to invest in Twitter.

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Fool contributor Tim Brugger has no position in any stocks mentioned. The Motley Fool recommends, Intel, and Twitter. The Motley Fool owns shares of and Intel. 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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