Four extremely overpriced stocks

We think these companies' share prices are pricing in overly optimistic expectations.

Karen Wallace 7 May, 2018 | 5:00PM
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When Morningstar analysts determine a company's fair value estimate, we focus on fundamentals such as a company's competitive advantages and cash flows -- which we believe are crucial to valuing companies as businesses.

We believe that buying a stock means becoming part owner in a business and that over the long run, stock prices are ultimately driven by corporate financial performance. We base our fair value estimates for stocks on the present value of the company's future cash flows, not on stock-price momentum or investor sentiment.

Our opinion of whether a stock is undervalued or overvalued often doesn't jibe with so-called consensus opinion. Sometimes a majority of Wall Street analysts thinks a stock is a strong buy, but our analysts aren't quite as bullish.

The average analyst price targets for the four companies below indicate that the consensus views the stocks as fairly valued or even a bit undervalued. But Morningstar analysts believe these stocks are very overvalued relative to our estimates of their fair value.

 Dropbox (DBX)
Price: US$30.14
Morningstar Fair Value Estimate: US$14
P/FV: 2.15
Average Analyst Price Target: US$33

Dropbox was overvalued right out of the gate, according to equity analyst Billy Fitzsimmons. The file storage software company began trading on March 22 in the US$29-US$30 per share range, and it has remained there for the past month.

The main problem, in Fitzsimmons' view, is Dropbox's core business -- cloud storage, syncing and collaboration services -- have become commoditized. The services were revolutionary when Dropbox was founded in 2007, but well-capitalized rivals such as Microsoft and Google have since entered the space.

The service works like this: Users can synchronize files to Dropbox's proprietary servers, allowing the user to access the files on any device using Dropbox's applications and website. In recent years, Dropbox has attempted to rebrand itself as a collaboration business by introducing productivity applications to complement its storage offering. Dropbox has used a freemium model to aggressively expand to 500 million users. However, only 11 million users are currently paying for Dropbox's services, meaning the firm needs to demonstrate that it can effectively monetize its user base, says Fitzsimmons.

Fitzsimmons believes inroads must be made into the more lucrative enterprise market for Dropbox to succeed. In his view, a heightened degree of competition from well-capitalized rivals will limit Dropbox's ability to deeply penetrate the enterprise market, and we expect Dropbox's lack of a competitive advantage to weigh on the firm's operations over the ensuing years.

 Intuitive Surgical (ISRG)
Price: US$443.18
Morningstar Fair Value Estimate: US$257
P/FV: 1.72
Average Analyst Price Target: US$479

Intuitive Surgical makes robotic minimally invasive surgical products such as the da Vinci Surgical System. Regional equity director Alex Morozov believes the firm has dug a wide moat around its business through its expanding installed base of roughly 4,000 da Vinci systems and its vast procedure database.

Healthy system and instrument pricing reflects the firm's monopoly status in its niche, allowing Intuitive Surgical to achieve profitability rarely enjoyed by medical equipment makers, Morozov says. The firm's monopoly will sooner or later cease to exist, he says, as competitors move into the space, but as of now none of the emerging competitors have the potential to significantly disrupt the firm's operations or erode its returns on capital.

But while Morozov believes Intuitive's competitive positioning remains superb and the company still has a healthy growth profile, he thinks the firm will have trouble keeping pace with past growth rates.

"After a decade of explosive growth, Intuitive Surgical is becoming a victim of its own success, with tougher comps and challenges in its key procedures slowing its trajectory," Morozov said.

 Humana (HUM)
Price: US$283.34
Morningstar Fair Value Estimate: US$191
P/FV: 1.48
Average Analyst Price Target: US$303.63

Managed-care organization Humana has been highly successful over the past 10 years in expanding its business as millions of Medicare recipients migrated to Medicare Advantage (MA) plans. Senior equity analyst Vishnu Lekraj believes the stock is overvalued, however, and that growth expectations look too high.

Humana has done a solid job of navigating a tough operating environment, given a volatile health insurance market. Lekraj is impressed that the firm has robustly expanded its core MA and Medicaid businesses while preserving a decent level of profitability. However, Humana's reliance on Medicare as a long-term growth driver and core strategy will be a headwind, Lekraj says.

Much of the growth of MA products was due to outsize payment rates that were higher than those for original Medicare to motivate enrollment, Lejraj explains. But this trend will reverse as the federal government tries to push MA payment rates down to those of original Medicare. Therefore, Humana is in the most challenged position of its peers on a stand-alone basis, in Lekraj's opinion. It faces not only mandatory rate cuts but also potentially higher costs as the nation's older population increases its demand for healthcare without a corresponding increase in supply. Also, the implementation of exchanges and the stated strategic plans of other managed-care organizations will most likely increase competition in the MA market, he adds.

 Netflix (NFLX)
Price: US$309.19
Morningstar Fair Value Estimate: US$90
P/FV: 3.44
Average Analyst Price Target: US$333.12

Equity analyst Neil Macker assigns Netflix a narrow moat rating. Netflix is the largest subscription video-on-demand provider in the United States and is rapidly expanding its subscriber base internationally (over 90 million worldwide). In Macker's view, this creates a humongous data set that Netflix mines in order to better purchase and create content. This new content not only strengthens its relationship with its current customers, but also attracts new customers via word of mouth and the halo effect from critical acclaim and award nominations.

Investors have been very optimistic about Netflix’s prospects as the firm continues to report strong subscriber growth and beat its guidance: The stock is up 63% for the year to date and more than 100% for the trailing one-year period. While Macker concedes that the subscriber growth reported in the March quarter is good news, he is troubled by the fact that the firm pushed its content and marketing spend into the second half of the year. As a result, the free cash flow loss for the quarter was only US$287 million, an improvement sequentially from the loss of US$524 million in the fourth quarter. However, management continues to project free cash flow burn of US$3 billion to US$4 billion for 2018, up sharply from a US$2 billion loss in 2017.

Despite the beat on subscribers, therefore, Macker believes the firm will face increased competition over the next five years, necessitating an ongoing cash burn and limiting the rate of margin expansion. At a price/fair value of 3.44, the stock appears very overvalued today.

Stock prices as of May 3. Average analyst price target data from Yahoo Finance.

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Karen Wallace

Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.

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