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(laurent Renault/Getty Images/iStockphoto)
(laurent Renault/Getty Images/iStockphoto)

Equities

Bubble or no bubble? Finding the stocks worth their lofty valuations Add to ...

Bubble. You heard that word a lot this year as U.S. markets hit record highs. You heard it most frequently in the case of a handful of hot stocks that racked up mega-returns of 50 per cent or more.

But are those stocks really bubbles? Granted, they’re frothy, but there’s a big difference between a stock price that reflects an aggressive appraisal of future prospects and a stock price that appears to have lost all touch with economic logic. Only the latter deserve to be labelled with the b-word.

Of course, bubbles are always a matter of opinion until they pop – and that’s what makes assessing them so entertaining. To frame the discussion, here’s a year-end guide to some of the hottest names of 2013 and my take on whether they’re bubbles.

Kacper Pempel/REUTERS

Twitter Inc.: No bubble

If you’re a skeptic about Twitter’s prospects, there’s plenty of ammunition close at hand.

The company has no profits. Its stock has more than doubled in the seven weeks since its November debut. Trading at 40 times sales, it’s many times more expensive than many other companies in the social-media industry.

Still, many of the criticisms levelled at Twitter were also once aimed at LinkedIn and Facebook – two other stocks that will likely never see their post-IPO lows again.

What all these social-media companies share is a business model that can add more users at next to no cost. This makes each new person highly profitable – and, to sweeten the deal even further, each new user makes the service that much more valuable to existing users. This is called the “network effect” and can result in explosive growth as a expanding membership makes a social-media hub even more attractive to spiralling numbers of additional users.

In its short life, Twitter has become the wire service to the world. With very little effort, it already generates a dollar in sales for every few hundred tweets. Its “sponsored tweets” and other money-making initiatives are in their infancy and look sure to grow rapidly. As hard as it may be for value investors to believe, Twitter’s share appreciation may be in its infancy as well.

Noah Berger/REUTERS

Tesla Motors Inc.: Bubble

Few dispute the quality of Tesla’s vehicles. The company’s Model S was named top car of the year by Consumer Reports, the bible of finicky buyers everywhere. But the company’s shares, which rose nearly 350 per cent this year, have sped ahead even faster than its automobiles.

The stock is now priced on the belief that Tesla’s electric vehicles will be more than just toys for affluent environmentalists. Many analysts are looking out nearly a decade and forecasting a mass-market future for the company, in which it sells hundreds of thousands of cars at prices comparable to competitors’ basic gas-driven models.

Sure, that’s conceivable – but it’s a huge extrapolation from the present day. Tesla will sell only 20,000 or so cars this year, at prices that can easily top $100,000 (U.S.). The feasibility of cheaper models remains unproven. And if the market for electric vehicles proves as robust as Tesla enthusiasts expect, the company is going to face competition from many other auto makers.

None of those uncertainties are reflected in Tesla’s share price. Even after a recent decline, the company has a market capitalization of roughly $19-billion – or about one third the value of General Motors Co., which sells more than 100 times as many cars as Tesla. Recent reports of fires in Tesla’s cars and a missed earnings report suggest investors should consider whether this stock might shift into reverse.

Netflix Inc.: Bubble

Who knew that one well-received Kevin Spacey drama was worth $15-billion? That’s roughly how much market capitalization Netflix added in 2013 as its shares nearly quadrupled on excitement that rested, in large part, on the success of House of Cards, an original Netflix series. The critical acclaim for it and the prison drama Orange is the New Black led many to dub Netflix the new HBO and forecast the company will eventually have the profit margins of a premium cable channel.

The problem with this happy notion is that Netflix owns neither the content it delivers nor the pipes it delivers them through. It depends on Internet providers to carry its bandwidth-clogging content to users. More importantly, it only has limited distribution rights to House of Cards and other series; their creators and studios stand to profit from DVD sales and other future streaming opportunities.

So far, the healthy growth in subscribers has suggested the series are winners (although Netflix won’t release actual viewership numbers). But if growth slows or stalls when Netflix’s greatest hits can be viewed elsewhere – well, House of Cards will take on a whole new meaning.

Amazon.com Inc.: No bubble

There are plenty of reasons to hate Amazon, the stock. The company perennially finds a way to spend all the money it takes in and nearly always reports razor-thin margins, or even losses, despite growing sales. Yet despite its sad-sack bottom line, the shares still gained nearly 60 per cent this year and now trade at 177 times their expected profit for the next year, according to Standard & Poor’s Capital IQ. For bargain hunters, that’s a frighteningly high valuation.

But for every reason you can find to despite Amazon’s stock, there’s a reason to love its business. Quite simply, the company is excellent at serving its users. It has built a seemingly impregnable position as the king of online retailing and it is an emerging giant in delivering content streaming and web services.

Those losses? They’re not because of bad execution, but because Amazon is spending heavily on building new fulfilment centres and adding computer servers to better serve its customers.

Critics say the company’s low margins are the result of a shift away from books and other media to general merchandise, as well as its decision to sell Kindle tablets at cost to benefit from as-yet-unrealized digital media sales.

Despite those impediments, Amazon will cross $100-billion in annual sales some time in the next year or two. At some point, it will be able to slow down its investment in building new capacity, and at that point it should be able to increase its margins to the high single digits. That would result in earnings of $20 a share or more – making today’s $400 share price much more understandable. Bet against founder and CEO Jeff Bezos at your peril.

Tim Post/AP

LinkedIn Corp.: No bubble

LinkedIn has been on a growth spree. As a result, the company’s price-to-earnings ratio stands at a lofty 112 – but that P/E is based on a deeply depressed E, the result of spending to continue the company’s international expansion.

LinkedIn has gross profit margins of 87 per cent, far superior to Facebook’s 76 per cent and Google’s 57 per cent.

However, LinkedIn’s growth spending drives down the company’s operating margin to just 2.5 per cent, versus 15 per cent for Facebook and 21 per cent for Google.

Just as with Amazon, a dialling down of growth spending and an expansion of margins would cause earnings to jump. Like Facebook, LinkedIn has no clear competitor in its social-networking space; it’s rapidly become the go-to spot for companies to find candidates for openings. It’s found ways to increase user engagement by offering posts by experts and a feature where members can endorse their connections for various skills. Don’t be surprised if investors endorse LinkedIn for future gains.

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