Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Rackspace Hosting, Inc. (RAX), Amazon.com, Inc. (AMZN), And Battling Giants

And then there’s Microsoft Corporation (NASDAQ:MSFT). Microsoft’s Azure cloud platform competes directly with Amazon.com, Inc. (NASDAQ:AMZN)’s web services and Rackspace, and having a company with the resources of Microsoft Corporation (NASDAQ:MSFT) competing with you is never a good thing. Recently Microsoft Corporation (NASDAQ:MSFT) announced that it would match Amazon.com, Inc. (NASDAQ:AMZN) web services prices for commodity services, further pressuring Rackspace’s prices.

It’s hard to bet on Rackspace with both Amazon and Microsoft Corporation (NASDAQ:MSFT) aggressively slashing prices. Amazon.com, Inc. (NASDAQ:AMZN) has claimed some big customers for its web services, like reddit.com and Yelp, and you can see a full list here. And with Microsoft Corporation (NASDAQ:MSFT)’s price cuts I would expect Azure to grow rapidly as well. It will be very difficult for Rackspace to grow anywhere near its historical rates with the kind of competition its facing.

What were people thinking?

Rackspace stock traded as high as $81 per share at the beginning of this year, then proceeded to plummet to around $45 per share. It recovered slightly to the low $50s, but now it sits just below $40 per share after the Q1 earnings report.

This is a stock that had an EPS of $0.75 in 2012. It was trading at a P/E ratio of over 100 at the beginning of the year, and before this earnings report the P/E ratio was still a staggering 70. Even now, after the big drop, the P/E ratio still sits at around 53. The valuation has gone from being absolutely insane to just marginally insane.

If the company could actually grow earnings at 50% per year for the foreseeable future then maybe these high ratios are justified. But it can’t, and it won’t. Growth will almost certainly slow as the company is faced with well-funded and aggressive competition. Even if EPS could be grown at, say, 20% annually a P/E ratio of 53 is bonkers, let alone a ratio of 100. This is what happens when you pay 100 times or 70 times earnings — you get burned. And if you pay 53 times earnings now you’ll likely get burned again.

The bottom line

When a stock sinks 25% because earnings miss by a penny then it’s likely dramatically overvalued. Rackspace is a fine company with good margins but it has been bid up to outrageous prices. Even after the 25% drop it’s still way too expensive. Rackspace was a ticking time bomb at $80 per share, it was a ticking time bomb at $53 per share, and it’s likely a ticking time bomb at $40 per share. The next time the company disappoints, expect more pain.

The article How to Tell If a Stock Is Overpriced originally appeared on Fool.com is written by Timothy Green.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

DOWNLOAD FREE REPORT: Warren Buffett's Best Stock Picks

Let Warren Buffett, George Soros, Steve Cohen, and Daniel Loeb WORK FOR YOU.

If you want to beat the low cost index funds by 19 percentage points per year, look no further than our monthly newsletter.In this free report you can find an in-depth analysis of the performance of Warren Buffett's entire historical stock picks. We uncovered Warren Buffett's Best Stock Picks and a way to for Buffett to improve his returns by more than 4 percentage points per year.

Bonus Biotech Stock Pick: You can also find a detailed bonus biotech stock pick that we expect to return more than 50% within 12 months.
Subscribe me to Insider Monkey's Free Daily Newsletter
This is a FREE report from Insider Monkey. Credit Card is NOT required.