Internet stocks are down 15% since the end of February compared to a 5% rise by the S&P 500 over the same period, but they have still solidly outperformed the index if you measure from the beginning of 2013 and recent gains are making the gap even wider. While multiples remain above their post-crisis average, performance has diverged in the sector, with top performing stocks gaining 40% while the worst performing plummet just as far since February. These price dislocations create the perfect environment for stock pickers, though they will have to look at more than just growth, says Goldman Sachs analyst Heath T. Perry.
“While we believe the recent sell-off has created opportunities in Amazon.com, Inc. (NASDAQ:AMZN), Priceline Group Inc (NASDAQ:PCLN), Twitter Inc (NYSE:TWTR), Pandora Media Inc (NYSE:P), LinkedIn Corp (NYSE:LNKD), RetailMeNot Inc (NASDAQ:SALE) and Shutterfly, Inc. (NASDAQ:SFLY), we expect continued volatility as earnings catch up to valuations and deal-related supply is absorbed,” he writes in a June 11 report.
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Internet sector forward EV/EBITDA a full standard deviation above average
Forward EV/EBITDA for the sector has fallen from a post-crisis high of 27x to 23x, but that’s still a full standard deviation above the five-year average of 15x and objectively expensive by most standards. Weighting forward EV/EBITDA by market cap pulls the multiple down to 18x, but it doesn’t change the overall picture.
Internet stocks are currently overvalued
But even this might underestimate the extent that internet stocks are currently overvalued. Of the top ten internet stocks by market cap, only six are above their five-year average EV/EBITDA, which seems reasonable. But LinkedIn and Twitter don’t have real five-year averages, having gone public in May 2011 and November 2013 respectively, so any comparison to their ‘historical average’ is misleading.
Free cash flow yield could be a key differentiator
Growth stocks like Twitter Inc (NYSE:TWTR) were hit particularly hard in recent months, and Perry thinks that tech investors are finally making profitability a bigger part of their stock picking strategy. To avoid getting caught holding another growth stock without much inherent value, he recommends considering free cash flow yield metrics as a key differentiator among high growth internet stocks.
In particular, he recommends Buy-rated Endurance International Group Hldgs Inc (NASDAQ:EIGI), LinkedIn Corp (NYSE:LNKD), Priceline.com Inc (NASDAQ:PCLN), RetailMeNot Inc (NASDAQ:SALE), and Shutterfly, Inc. (NASDAQ:SFLY) as internet stocks to keep an eye on for their strong free cash flow yields.
He also sees the possibility to cash in on discrepancies between changing growth expectations and multiple expansion. Buy-rated Twitter Inc (NYSE:TWTR), RetailMeNot Inc (NASDAQ:SALE), Endurance International Group Hldgs Inc (NASDAQ:EIGI), and Pandora Media Inc (NYSE:P) all have low multiple expansion relative (though, in the case of Twitter both are negative).