Should You Be Scared to Hold These 3 Companies Ahead of Earnings?

Netflix has been one of the greatest momentum stocks of the last year, and after reporting earnings, it initially traded considerably higher. However, we then saw a change in perception, and profit taking. This fact might prove worrisome for shareholders of other momentum stocks, and especially three stocks in particular.

A sign of things to come?
By most accounts, there wasn't anything superior about Netflix's quarterly report . The company met revenue expectations and beat EPS estimates by $0.03, posting earnings of $0.52 per share.

The most striking metric might be the 1.29 million subscribers added, versus the 630,000 that were added in the company's previous quarter. Therefore, total subscribers now stand at 31.09 million, and many believe that Netflix will aim to create more original shows thanks to its early success.

Initially, the reaction to this quarter was euphoric, as the stock gained nearly 10% on top of its 5% gains from the day prior. The stock was very close to $400 in premarket hours, but then once the market opened, shares nose-dived to $320.

Notably, nothing fundamental had changed. The company's revenue growth was 5% and its margins improved. However, this quick reaction and the sudden move lower should make many very wary as other momentum stocks face earnings.

With that said, we are facing a situation where many of the market's best performing stocks trade at insane multiples to fundamentals, have high expectations with large YTD gains, and trade with extremely high betas (a stock's volatility compared to the market). In particular, there are three that come to mind:

Don't expect a repeat of recent history!
Facebook's first quarter earnings report was truly remarkable, as the company proved most of its naysayers wrong, and solidified the long position for ongoing investors. In previous quarters, revenue had decelerated, but Facebook surprised the market with 53% growth rather than sub 35% growth.

Moreover, mobile finally became relevant for Facebook, accounting for more than 40% of total revenue. In addition, Facebook guided for lower costs and new exciting services. Now, fast-forward three months later and Facebook's stock has more than doubled, and it is a $130 billion company!

Thus, the pure size of this company makes it a risk, and the fact that it trades at 21.5 times sales. When a company is valued at less than $20 billion, massive premiums can be sustained, as there is always new money on the table. But for a $130 billion company, we are reaching a point where fundamentals and valuation must at some point align. Hence, I'd be careful ahead of earnings on October 30, because there is likely more downside than upside. Nonetheless, I wouldn't expect another double in the next three months.

At some point the bubble must burst?

Staying on the same subject, LinkedIn is another social media stock with an insane premium compared to fundamentals. However, unlike Facebook, LinkedIn's valuation has been consistent, and not all of a sudden.

In the last year, LinkedIn has gained 130%, and now trades at 22.5 times sales. In the company's last quarter, revenue growth was 59%, which adds to a continued trend of lower year-over-year growth that we've seen in recent quarters.

Below, you can see a chart which shows the company's year-over-year growth over the last six quarters. Quickly, you'll see a trend.

Quarter (Q) -- Year

Revenue Growth

Q2 -- 2013 


Q1 -- 2013 


Q4 - 2012 


Q3 -- 2012 


Q2 -- 2012 


Q1 -- 2012 


Like I said, each quarter the company's year-over-year growth has decelerated. Yet, its premium to both net income and revenue continues to rise. Sooner or later, this trend will end, and for current investors, you have to at least wonder if October 29 might be that ending quarter.

Will reason finally defeat irrational exuberance?
For as crazy as the valuations of LinkedIn or Facebook might seem, no company comes close to the premium on Workday .

Workday is a HR/payroll company that offers its services through the cloud, one with trailing 12 months sales of just $353 million , but a market cap of $13.87 billion! In other words, Workday trades at a whopping 40 times sales!

Moreover, Workday is not profitable; it has operating margins of negative 35.4%. Also, with the exception of its most recent quarter - historically a strong quarter for cloud-based company - revenue has consistently declined year-over-year.

Therefore, the same argument that applies to LinkedIn and Facebook is also relevant to Workday: How many more quarters can this stock trade higher until the market suddenly and abruptly corrects its valuation? The only difference is that due to its valuation, Workday is an even more extreme case. Because in the case of LinkedIn and Facebook, at least both of these companies are profitable. Thankfully, investors have time to reassess their position, as Workday doesn't report earnings until November 25.

Final Thoughts
Compared to these three noted companies, Netflix is cheap! Netflix trades at just five times sales, thus the overall fickleness of investors should serve as a warning sign to shareholders of other momentum stocks.

If I had to pick one at the greatest risk of post-earning declines, it would have to be Workday, as it trades with by far the most illogical valuation. To put its valuation in perspective, if Netflix traded with Workday's price/sales ratio, it would trade at more than $2,500 per share! Clearly, this price is insane, as is the valuation of Workday.

In the case of LinkedIn and Facebook, there is still quite a bit of excitement surrounding the future of these companies. However, with valuations of 20 times sales or more, there is definitely a great deal of risk with minimum reward. Thus, I'd be very cautious ahead of earnings next week, and would be scared to death if I owned Workday ahead of its report.

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The article Should You Be Scared to Hold These 3 Companies Ahead of Earnings? originally appeared on

Brian Nichols owns shares of Apple. The Motley Fool recommends, Apple, Facebook, Google, LinkedIn, and Netflix. The Motley Fool owns shares of, Apple, Facebook, Google, LinkedIn, and Netflix. 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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