Searching for the next addition to your portfolio makes it easy to get caught up in the excitement surrounding the latest Wall Street darlings. Yet, not all hyped stocks have promising prospects. In fact, some high-flying stocks carry significant risks that can jeopardize your wealth-building efforts.
One of the most identifiable risks is a stock’s valuation. Overhyped stocks often trade at inflated valuation multiples. Occasionally, these multiples are justified by the stock’s underlying growth. Other times, the stock falls short of market expectations, leading to a valuation compression and, thus, significant downside potential.
In this article, we are focusing on the second case. I have selected three hyped stocks to avoid that are currently trading at rather rich valuations. Their valuations can hardly be justified even when employing Wall Street’s optimistic future growth potential. This makes them risky bets that could hamper one’s investment journey.
DexCom (DXCM)
The first stock to avoid at its current price levels is DexCom (NASDAQ:DXCM). If you are unfamiliar with the company, Dexcom is leading the glucose monitoring space. Its systems have revolutionized diabetes management by providing real-time glucose monitoring, thus substantially improving the lives of diabetic patients.
Wall Street has been incredibly bullish on DexCom for years, with investors willing to shell out exorbitant multiples to secure a stake in the company. Despite the stock hovering near the same levels as three years ago, it remains disproportionately pricey. Investors are now paying 65 times this year’s anticipated earnings per share (EPS) and 52 times next year’s EPS.
Investors’ willingness to pay such steep valuations is ingrained in several compelling factors. Firstly, Dexcom’s continuous glucose monitoring (CGM) devices are praised for their high precision and dependability, suggesting Dexcom is set to dominate this space for decades to come. Secondly, Dexcom is experiencing robust growth, boasting an impressive 10-year compound annual growth rate (CAGR) of 36.6% despite already sustaining nearly two decades of expansion.
However, given its current valuation, investors’ potential total returns could be limited. Even if DexCom continues to meet or exceed Wall Street’s expectations, its shares may struggle to appreciate as the company grows into its current valuation multiples. This trend has persisted for about three years, during which DexCom has seen substantial revenue growth without actually recording share price gains.
TransDigm Group (TDG)
The second stock I would avoid at its current levels is TransDigm Group (NYSE:TDG). Don’t get me wrong, there is a lot to like about this company, which might explain the never-ending share price rally in recent years. In the meantime, however, the stock’s valuation has expanded so much that I don’t see how the company’s underlying EPS growth can support it.
Regarding why Wall Street loves TDG stock and keeps driving shares higher by the week at this point, you have to take into account a major key factor. Essentially, TransDigm boasts a portfolio of proprietary products in the aerospace and defense industry, providing it with massive barriers to entry. Some of the most sophisticated weapons systems employed by the U.S. military need TransDigm’s parts, ensuring consistent demand and huge pricing power.
For this reason, the market anticipates that the company will sustain rapid growth in both revenues and profits for the foreseeable future. This trend has persisted over the years and is now further backed by the ever-volatile geopolitical environment we are undergoing, further bolstering the stock’s bullish case. Yet, at about 40 times and 34 times this and next year’s expected EPS, respectively, TDG is one of the most expensive stocks to avoid in the space. Thus, a valuation compression to more reasonable levels wouldn’t surprise me.
Datadog (DDOG)
The last of stocks to avoid is Datadog (NASDAQ:DDOG). While Datadog has been in the public markets for less than five years, it has rapidly established itself as a leader in the cloud monitoring and analytics space. Its solutions blend metrics and logs and offer useful insights into performance and security, and have thus become vital for about 28,000 customers, including most of the world’s largest companies.
The company is leveraging the rapid adoption of cloud computing, capitalizing on the trend toward digital transformation and hybrid cloud environments while consistently expanding its product portfolio. For example, last year Datadog introduced Workflow Automation and Netflow Monitoring, alongside other solutions. Its critical services and effective cross-selling strategies have consistently contributed to net retention rates of around 110%. Moreover, with a steady influx of new customers, Datadog has achieved a remarkable five-year CAGR of 60.8%.
Will Datadog continue to grow aggressively in the current market environment? I have no doubt. Still, at about 75 times and 61 times this year’s and next year’s expected EPS, there is also no doubt that investors are paying a hefty premium for the stock. These P/E ratios could easily limit investors’ total return prospects moving forward. In fact, the stock is now trading at levels comparable to those seen in February 2021 as it continues to strive to align with its lofty valuation multiples. Thus, beware of Datadog at its current levels.
On the date of publication, Nikolaos Sismanis did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.