Here Is Why You Should Avoid Highly-Valued Stocks

GoPro Inc and Twitter Inc are U.S.-based companies that even Singaporeans are likely to be familiar with.

Both investors and the media had high hopes for the two companies. Stories like how a video camera maker (GoPro) is “conquering the world” and how a website that allows users to broadcast 140-character posts (Twitter) will “change the world” were not uncommon back in 2013 and 2014.

As a result of the love, the share prices of the two companies soared through the roof. GoPro shares climbed to a high of more than US$93 in late 2014, clocking a price-to-earnings (PE) ratio of nearly 300. Meanwhile, Twitter shares peaked at over US$73 in late 2013, valuing the company at US$50 billion.

What’s interesting about Twitter when its shares peaked was that the company had never been profitable up till that point (in fact, the company is still unprofitable).

Twitter has publicly available financials that stretches back to 2010, a year in which the company lost US$67 million. By 2013, Twitter’s loss had ballooned to US$645 million (over the 12 months ended 30 September 2015, the company’s loss stood at US$556 million).

Both GoPro and Twitter had enjoyed very positive sentiment in the market – the “fast-growing company” status – in the last two years. So, where are their share prices at today? GoPro and Twitter closed at US$18.22 and US$22.97, respectively, on Christmas Eve. That’s a decline of around 80% for the former and 70% for the latter. What has gone wrong here with the two companies?

Thing is, there can be a huge difference between expectations and reality. As investors, we have to be clear on that difference. If we are too caught up with wild expectations that have been placed by the market on a company’s stock, we may trap ourselves into overpaying for the stock. As we’ve seen from the examples above, overpaying for something isn’t fun.

There are companies in Singapore’s stock market that are also trading at high valuations. These companies include Q & M Dental Group (Singapore) Limited (SGX: QC7), iFast Corporation Ltd (SGX: AIY) and Yoma Strategic Holdings Ltd (SGX: Z59) – the trio are all trading above 30 times their respective trailing earnings.

Company PE ratio (28 December 2015)
Q&M Dental 41.4
iFast 32.7
Yoma Strategic 39.9

Source: S&P Capital IQ

Are investors in Q&M Dental, iFast, and Yoma Strategic Holdings overpaying for rosy outlooks on the future of the companies that are not reflective of reality?

It depends. Not all companies trading at high PE ratios would turn out to be bad investments. But there is certainly a heightened valuation risk for investors when investing in high PE stocks. The only way for us to avoid falling into the trap of overpaying is to ensure that we have done sufficient research on the company to be satisfied about its growth prospects before investing.

For more investing commentary and analyses, and to keep up to date on the latest financial and stock market news, sign up now for a FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

Also, like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim does not own any companies mentioned above.