Motley Fool contributor Claude Walker's excellent article on the comparative overvaluation of 'trendy disruptors' such as XERO FPO NZ (ASX:XRO) had me thinking yet again about the madness of markets. Xero's product range is not in the same league as MYOB, Reckon Limited (ASX:RKN) or even the small Australian accounting system provider Saasu, let alone global giants like Intuit. What Xero does have is an attractive interface, the novelty value of being the new kid on the block and extremely slick marketing tactics.
Although take up rates look impressive they are mostly confined to the low margin micro business segment and there is limited penetration into high-yielding segments due to the lack of depth in the offering. Even on the most optimistic scenarios (1 million paying customers within five years) Xero may be struggling to turn a profit. The oldest Software as a Service (SaaS) provider SalesForce.com was established in 2004 – 10 years later it is yet to generate meaningful profits despite consistent and stellar rises in customer numbers.
Xero is making an aggressive move into the US market – here it will be up against other new entrants in the accounting SaaS area such as Outright, Wave (free software) and the UK's FreeAgent – not to mention the present incumbents all of whom are increasingly moving onto the Cloud.
Any attempt to work out the present value of Xero is based on subjective factors and essentially guesswork. Potential investors in this company should note the significantly negative operational cash flows and the likelihood of further capital raisings to support growth projections.
Despite a recent fall in price REA Group Limited (ASX:REA) is still overpriced on medium-term prospects. Although dominant in the real estate space it's worth remembering we're at the end of a two decade long boom in housing prices – the fundamentals in this industry don't support a continuation of boom conditions. In addition rivals such as Onthehouse Holdings Ltd (ASX:OTH) are starting to snap at REA's heels. At present prices ($46.23) these factors alone are flashing amber.
Foolish takeaway
Making an investment is easy; assessing the risks in investment decisions is difficult – we all have individual risk tolerances after all. Value investing is about incorporating risk in your decision making as well as basic fundamental analysis. In my view both Xero and REA Group have excessively unrealistic expectations built into their current prices and don't provide any fodder for value orientated investors.
