Is Twitter cheap or expensive?

Is Twitter (TWTR)  cheap or expensive? After the microblogging company announced this week the price range for its initial public offering, many analysts said it was lower than expected, a sign that Twitter wanted to ensure a successful start to its life as a public company.

Yet, even with its more cautious pricing, the company still will be overvalued, according to at least one common valuation model. Twitter is a good example of why cautious investors should steer clear of young and hot technology companies.

To be sure, determining a fair price for Twitter isn't easy, according to Malcolm Baker, a professor at Harvard Business School, as is the case for almost all young growth companies. "The long-run case for investing in Twitter has to be based on the expectation that it will experience a huge growth rate in revenues and profits," he says.

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Google (GOOG)  comes to mind, of course. Its sales have risen from $1.5 billion in the year before its 2004 IPO to more than $40 billion in its most recent year, and its stock price has skyrocketed from an IPO of $85 to over $1,000. But most newly public companies don't expand as fast as the Internet search giant did, and there is no way of knowing whether Twitter will follow in Google's footsteps.

"Unless you have had a really clear sense that you can differentiate a Google from another company that won't experience the phenomenal growth necessary to support its stock price, then — given their potential for overvaluation — staying away from emerging-growth companies has been the best strategy," Baker says.

This potential for overvaluation is particularly elevated "when investor demand for IPOs is high, as reflected in a large number of IPOs coming to market," says Martin Kenney, a professor at the University of California, Davis, and an expert on IPOs. And now may be just such a time, he says: "There have been a lot of IPOs coming out over the last three to four months. Venture-capital firms appear to be just shoving them out the door."

According to investment bank Renaissance Capital, in fact, there were 60 deals in this year's third quarter, more than double the 26 in last year's third quarter. "The U.S. IPO market is on track to see record levels of post-tech-bubble issuance," the firm said.

Click to Play Twitter IPO: $11.1 Billion Valuation

Twitter set its price range for its initial public offering at $17 to $20 a share, in a deal that values the company at up to $11.1 billion. WSJ's IPO reporter Telis Demos reports. Photo: Getty Images.

Twitter's market capitalization at IPO will be $12.9 billion, assuming its shares will be priced at the midpoint of the $17 to $20 range contained in a filing this past Thursday. Note carefully that this total reflects, as it should, the number of shares from stock options and restricted shares.

We can't judge whether this $12.9 billion market cap is a fair valuation in terms of a price/earnings ratio, though, as the company is losing money. In fact, its losses are accelerating, with Twitter posting a $64.2 million loss in its September quarter versus a $42.2 million loss in the prior quarter.

It isn't particularly unusual for technology companies to be losing money when they come to market, since firms at early stages of their growth cycle often sacrifice earnings in order to invest in future growth. That is why, according to University of Florida finance professor Jay Ritter, many analysts focus on sales when valuing startups and IPOs — specifically, the ratio of a company's market cap to its total sales.

Since Twitter's sales over its most recent four quarters totaled $534 million, the company's price/sales ratio would be 24.1. That would be almost as high as Facebook's 25.8 ratio at its IPO.

In fact, according to data compiled by Ritter, a 24.1 price/sales ratio, or PSR, would be the third highest of any IPO since 1980 of any company that, like Twitter, had significant sales at the time it came to market. (Ritter determined which companies qualified for this comparison by calculating which ones had trailing four-quarter sales at IPO that were at least $500 million, in 2013 dollars.)

Besides Facebook, the only other new issue that had a higher ratio at IPO was Palm, the hand-held device maker, whose PSR at its March 2000 IPO was 29. Like Facebook, Palm's stock fell sharply over its first six months as a publicly traded company.

Palm's experience is more the rule than the exception for IPOs with high PSRs. The 15 with the highest PSRs when coming to market lost an average of 5% over their first six months, according to Ritter.

One reason that a high PSR creates such headwinds for a company's shares following its IPO is that the ratio almost always declines as the company matures, often markedly. The S&P 500's current PSR, for example, is 1.4. And as the PSR declines, revenue has to rise that much faster for the stock price to just stay even.

Consider, for example, what Twitter's market cap would be in five years' time should its revenue increase at the average pace of new companies that did IPOs between 1996 and 2005. That average five-year revenue growth is 212%, according to research conducted by Ritter and Kenney and Donald Patton, a research associate at the University of California, Davis. If Twitter's revenue were to grow at that rate, its revenue in the fall of 2018 would be $1.7 billion.

Internet companies tend to trade at higher PSRs than the broad market, so — to be generous — let's assume that Twitter's will be the same as other Internet companies on the fifth anniversary of their IPOs. According to FactSet, the median PSR of the companies in the Dow Jones U.S. Internet Index on their fifth birthday was 5.87.

Given these revenue-growth and PSR assumptions, Twitter's market cap in November 2018 would be $9.8 billion, or 24% below the $12.9 billion market cap the company will have assuming its IPO is priced at the midpoint of its indicated range.

If you really want exposure to the Internet, a better strategy might be to invest in more established companies. Several within the Dow Jones U.S. Internet Index (DJINET)  are currently recommended for purchase by at least two of the three dozen advisers on the Hulbert Financial Digest's monitored list who have beaten the Wilshire 5000 index (XX:W5000)  over the last 15 years.

On the list are Google and web portal Yahoo (YHOO)  . To be sure, since both companies' P/E ratios currently are at 20, versus 16.2 for the S&P 500, neither is especially cheap. But their PSRs are far lower than Twitter's is slated to be at its IPO: Google's is 6.0, according to FactSet, and Yahoo's is 7.3.

Also receiving at least two buy recommendations from these market-beating advisers are two non-U.S. companies: Yandex (YNDX)  , the Russian search engine, and Qihoo 360 Technology (QIHU)  , the Chinese Internet company. Both also sport P/Es that are well above the market: Yandex's is 28 and Qihoo's is 51. Yet their PSRs are also lower than Twitter's, at 12 and 15.9, respectively.