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Is it time to trade in Trade Me?

According to a report in The Australian Financial Review, New Zealand’s answer to eBay, Trade Me Group (ASX: TME), has been downgraded to a sell by UBS broker Richard Eary. The company is currently trading on 24 times earnings, however Eary expects Trade Me to only grow earnings at around 13% in financial year (FY) 2013. While in its own right 13% earnings growth might sound pleasing, paying 24 times earnings for that growth does not!

A look across the online sector highlights to investors the current necessity for companies to maintain high growth rates, as they are priced for perfection. Put another way, investors who choose to pay a high price for a company because of expectations of a high growth rate become reliant on the company delivering that expected growth; otherwise the share price is likely to re-rate lower and the investor to suffer at least a temporary capital loss.

Three other companies that will need to maintain their high growth rates to justify their high multiples include:

Carsales.com (ASX: CRZ), which trades on close to 26 times FY13 earnings. If Carsales.com can reach consensus earnings for 2014 then the PE does drop closer to 20 times. Webjet (ASX: WEB) currently trades on almost 24 times its historical earnings, while fellow travel market operator Wotif.com Holdings (ASX: WTF) is trading on an FY13 price-to-earnings multiple of 21 times, with earnings growth expected to decline in FY13 but bounce back to double digits in FY14.

The timing of Eary’s downgrades couldn’t come at a worse time for the sellers and stock brokers of the upcoming iSelect float. With the iSelect IPO priced for perfection and comparisons inevitably made to the valuation of other online businesses, cuts to peer valuation and subsequent falls in the share price of peers won’t help the iSelect sales process.

Foolish takeaway

Given the potential ease of entry for multinational competitors into the online classified and comparison advertising space, it is interesting to note the valuations of some potential competitors. Companies including Yahoo!, Google, eBay and Expedia are selling for closer to 15 times earnings. It’s always handy if investors can compare the value of an investment against a peer. Where possible it is good to also compare with overseas-based peers, as sometimes the whole domestic market can be over- or undervalued.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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