In 1999, traders and everyone else seemed to believe that the Internet would change the world and any company with a website would be able to profit from that new reality. These stocks had so much potential that traditional valuation techniques didn't apply because pageviews were more important than earnings or revenue. The price-to-eyeballs ratio was touted as a replacement for the archaic idea of a price-to-earnings (P/E) ratio.
In the end, we discovered that the "E" in P/E ratio really does need to stand for earnings if a company is going to survive. And outrageously high P/E ratios are usually setups for short trades.
Since the dot-com bubble burst in 2000, traders have become more selective in Internet stocks, but excessive optimism does appear at times. Facebook (Nasdaq: FB) was offered to the public at a price that represented a P/E ratio of about 100. The stock has been in a downtrend since its very first trades. Gaming company Zynga (Nasdaq: ZNGA) is another struggling, high-profile Internet stock and Sourcefire (Nasdaq: FIRE) appears to be set to join the list.
Sourcefire provides a variety of Internet security solutions. The company's products are highly rated by experts in the field, but the stock price may have gotten ahead of the fundamentals. Competitors include Cisco Systems (Nasdaq: CSCO) and Juniper Networks (Nasdaq: JNPR). While those companies have lower earnings growth rates, they also have large market shares and significantly lower P/E ratios than Sourcefire.
In the past 12 months, Sourcefire earned 24 cents a share, giving the stock a P/E ratio of almost 200. Analysts are forecasting earnings of about 97 cents a share in 2013, and Sourcefire is trading at about 50 times next year's expected earnings. With earnings growth expected to be about 20% a year going forward, Sourcefire seems overpriced.
The weekly chart shows a possible double-top formation developing since March. The stock price has moved mostly between $45 and $55 and is now near the bottom of that range.
A breakdown in Sourcefire should take the price to about $35 a share based on the pattern. The depth of a pattern, about $10 in this case, can be subtracted from the breakout to find the downside target. That price target coincides with the 2011 high in Sourcefire, which should offer a support level near $35.
Fair value on the stock could be closer to $20 based on earnings forecasts. Many analysts consider a reasonable P/E ratio for any stock to be the earnings growth rate of the company, which would be about 20 for Sourcefire. With 2013 earnings expected to be close to $1 a share, that calculation points to a stock price of $20.
Earnings for the third quarter are scheduled to be reported on Oct. 29. That announcement could trigger a large price move in the stock. Recently, the company said it now expects earnings to exceed earlier guidance of 19 cents to 21 cents a share. Analysts had been looking for 21 cents.
Traders should wait for Sourcefire to break below the trading range before shorting the stock and use a stop-loss near the midpoint of the trading range at $50, offering a potential reward-to-risk ratio of about 2-to-1 on the trade.
Options are priced to reflect a high probability of a 20% move in Sourcefire before the March expiration date. Put options are priced at reward-to-risk ratios that offer more risk than a short trade.
Action to Take --> Sell Sourcefire short at $45 or less. Set stop-loss at $50. Set initial price target at $35.
This article originally appeared on TradingAuthority.com:
Sell This Insanely Overvalued Stock Short Before it Crashes and Burns