Last month on our blog we took a deeper look at the valuation of ROKU, one of our “Bubble Stocks 2.0.” Today, at the market close, ROKU’s stock was down a whopping 19% in just one day, and down nearly 30% for the week. In light of this steep drop, we thought it would be a good time to revisit our earlier post.
On August 13th, when we wrote our original post, ROKU’s stock was trading at $135/share. We began our analysis with a discounted cash flow (DCF) model. Our DCF model resulted in an implied stock price of $74.93. In arriving at that conclusion,we used what we felt were optimistic assumptions as inputs for the model. We felt the assumptions were optimistic because “they downplay the role of competition.” At the time we did not have a clear idea of exactly which specific companies would pose the biggest threat to ROKU. Rather, more broadly, it was in our estimation that ROKU did not have any particular advantage that would prevent competitors from entering the business and drive down prices. We felt the threat of competition was particularly pronounced because ROKU operates in a space that contains some of the biggest players in the world who would not be anxious to see Roku dominate a market important to them. On that basis, and because even with our optimistic assumptions of DCF value was less than $75, we recommended avoiding the stock. And for most of the next month, we turned out to be wrong. As we warned, bubble stocks can keep bubbling even when fundamental valuation models say they are overpriced and Roku did – rising to more than $175 per share.And then the competition entered. Facebook, Comcast, and Apple all announced new products that would compete with Roku. Comcast stated it would be giving its streaming device and software away for free. At that point, the bottom fell out of Roku’s stock.
This is a common problem with bubble stocks. Aggressive investors may be tempted to ride the wave believing they can get out before the drop occurs. But when news arrives, when competition enters, the drop can be breathtaking. Profits built over months or even years, can disappear in a heartbeat. We urge our readers to follow the list of bubble stocks on our website and to read our post on Visicalc for perspective. In the Visicalc post we note how easy it is to conclude competition can be held at bay when business is on the upswing. But that underestimates the vibrancy of markets. The Facebooks, Googles and Amazons that truly dominate markets are the exception rather than the rule.