A Temptation Worth Avoiding

 | Jul 31, 2014 | 1:00 PM EDT
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As a value investor I quickly realized one very important thing about investing: Growth is a key driver of value.

When I consider an investment undervalued, it's often based on the premise that the present value of the company's future cash flows are worth far more than the business is being valued at today. It's a premise that is fundamentally anchored in growth, or more specifically the growth of cash flow over time.

However, growth can be deceptively tempting, and that is where investors get into trouble. Wednesday, Twitter (TWTR) shares advanced more than 20% over an earnings release revealing a 24% jump in active users. Twitter didn't make any money, but Mr. Market decided to add nearly $5 billion to the company's valuation based on the addition of those new users. Twitter now has 271 million active users.

According to one analyst at RBC Capital Markets, Twitter "has the highest growth rates ... so we view the super-premium multiples as warranted." Even Goldman Sachs jumped on the bandwagon: "We continue to believe we are in the early stages of a very long growth cycle for Twitter..."

Interestingly, not one analyst referred to future earnings potential. Today's valuation is all based on the user-base. That user base will have to grow phenomenally to keep investors happy, and perhaps it will. After all, Facebook (FB) has 1.3 billion users vs. 271 million for Twitter. I suppose the excitement is over the notion that Twitter could be the next billion-user social media stock. But those users have to start generating cash. Otherwise, the value of Twitter is based on nothing more than the mood of the next investor and what he or she is willing to pay.

While I'm a big fan of Amazon (AMZN) as a business and Jeff Bezos as a CEO, I've been a big skeptic about the stock price and Amazon's valuation. At least in Amazon's case you have nearly $100 billion of revenue that is growing, and will likely create sizeable profits down the road. The jury is still out for Twitter.

Wall Street is in a happy place these days: low interest rates, tons of cash looking for a home, and economic numbers that create a warm and fuzzy feeling. That optimism is tempting money to chase growth at any cost.

That's a temptation best worth avoiding.



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