Watch Out for High-Priced Tech Stocks

Who could forget the late 1990s? Tech stocks sold for 100 times earnings and more, many companies had no profits, and some had no revenues. We all know how that party ended.

To say we're seeing a rerun of that lunacy today would be a gross overstatement. Most tech stocks are reasonably priced; in my view, many look attractive. But the valuations on a growing number of Internet stocks are just as nutty as they were in the '90s. These are stocks with price-earnings ratios of 50, 60 or even more than 100.

Just as in the '90s, most of these companies are working with promising, cutting-edge technologies. Some analysts project that their earnings will grow rapidly and long enough to justify the current high price-earnings ratios. But the odds of these companies growing into their stretched valuations are slim.

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Consider LinkedIn (symbol LNKD). It's a great company for job hunting and networking. It dominates its niche — and may well continue to for years to come. But its exorbitant share price already reflects a ton of wonderful growth. At $243.00, LinkedIn trades at 116 times the average of analysts' estimates for the coming 12 months. That price is also 23 times current sales. (All prices and related data are as of October 28.)

At the peak of the tech bubble, in March 2000, longtime bull Jeremy Siegel wrote a famous and uncharacteristically bearish piece for the Wall Street Journal. "History has shown that whenever companies, no matter how great, get priced above 50 to 60 times earnings, buyer beware," wrote Siegel, a finance professor at the University of Pennsylvania's Wharton School and a columnist for Kiplinger's Personal Finance magazine.

But here we go again — at least with some of today's sexiest companies. Not all of them fall into groups that are commonly considered to be tech. Look at Tesla Motors (TSLA), the hot new maker of green cars (see Tesla Take Off). At $162.86, it trades at 150 times estimated earnings for the coming 12 months and 14 times sales. It could turn out to be a transformative company, but it'll have to do a whole lot of transforming to ever support its current price.

Young companies, of course, often lose money, especially capital-intensive start-ups, such as Tesla. You can't run a car-assembly factory in your garage on a credit card. But start-ups are, by definition, high-risk; there are plenty of opportunities for the wheels to come off before a new company matures.

Salesforce.com (CRM) is a fast-growing company that sells software and services that enable its customers to conduct business in the cloud. "Connect to your customers in a whole new way with our apps," the homepage promises. But at $53.49 a share, the stock trades at 140 times estimated earnings. The San Francisco-based business is promising; the stock price is outrageous.

Price-earnings ratios are a blunt tool for measuring value. They're far from perfect. For one thing, with cyclical companies — that is, companies that tend to rise and fall with the economic cycle — you typically want to buy when P/Es are high or even nonexistent (because the company is losing money) and sell when P/Es are low. But as a general rule, it makes sense for investors to start their search for value by looking at a stock's P/E.

Among the best-known stocks with a sky-high valuation is Amazon.com (AMZN). Publicly traded since 1997, the online retailer is beloved by both consumers and investors. Its shares, at $358.16, change hands at 90 times earnings.

Want some other examples? Facebook (FB) trades at 56 times earnings, Groupon (GRPN) at 46, Netflix (NFLX) at 77, Shutterfly (SFLY) at 101, WebMD Health (WBMD) at 56, and Zillow (Z) at 165. Outside of tech, Chipotle Mexican Grill (CMG) trades at 41 times earnings, and Live Nation Entertainment (LYV) at 293.

I'm not arguing that Tesla or LinkedIn or any of the others won't beat the odds and make money for investors. Some high-priced stocks are also profitable investments. But investing in such overpriced stocks is a sucker's bet.

Why do investors, particularly professionals, buy these stocks? A lot of the buying is driven by computers and is often based on momentum: You buy a stock that has risen, hoping it will rise a bit more before you unload it.

But individual investors shouldn't play the momentum game. Buying an overpriced stock and hoping to sell it to a greater fool is a dangerous game that almost always ends badly.

Steve Goldberg is an investment adviser in the Washington, D.C., area.