In early February, Twitter's stock plunged by 24 percent in a single day. There was no disaster that suddenly befell the company, just an earnings report that was a bit of a reality check for starry-eyed investors.
Twitter still has its massive audience, but the sudden air pocket the stock hit serves as a reminder of some of the hazards of investing in a stock with a meteoric growth rate.
Why previously successful stocks fail
Twitter has succeeded in doing something that make it the envy of countless would-be competitors: It has built a membership of more than 200 million people. However, its biggest challenge may still lie ahead -- turning popularity into profitability.
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Here are seven of the hurdles companies with rapid initial growth have to clear in order to achieve lasting success:
- Sustaining an advantage. Success attracts competition. Twitter is not only vying for social media time with powerful firms such as Facebook and Google, but it has to fend off wave after wave of splashy new entrants into the space.
- Achieving scale. This is something that Twitter has done almost seamlessly, but that many companies struggle with: taking something that works well for a limited audience or customer base and executing it on a massive scale. Often, growth companies run into limitations of technology, logistics or talent that constrict growth.
- Turning attention into revenue. This has been the central challenge for Twitter and many other social media companies. They build a massive audience offering what is essentially a free service, and then have to figure out how to derive a revenue stream from it. What makes it tricky is that introducing commercial elements like advertising can turn off the audience a site has built.
- Finding the right profit margin. From an earnings standpoint, revenue is only half the battle -- costs must also be managed in order to achieve profitability. In particular, tech companies have a hard time weaning themselves off investment capital and operating as a going concern. Even then, the challenge becomes one of whether to defend a higher profit margin, or sacrifice margins in pursuit of faster growth.
- Retaining talent. Successful start-ups can lead to nearly instant wealth for the insiders who helped shape the company. The problem then is how to keep these new multimillionaires motivated and productive, and how to keep successful people from being lured by another venture.
- Sustaining their growth rate. At some point, this proves to be mathematically impossible for all companies. Eventually, they start to run out of new customers to capture. The trick for an investor is to recognize when and how a company's growth rate will tail off as it reaches maturity.
- Expectations. This is the biggest reason for Twitter's recent stock plunge: Overeager investors had driven the stock's price up sharply within weeks of the company's IPO. When expectations for a stock are high, don't expect it to be a bargain.
An investor has to think from both inside and outside the perspective of a company's management. Like that management, the investor has to understand the business plan to get a sense of how sustainable the company's success is. In addition though, the investor has to weigh the price the market is demanding for the stock in order to avoid paying too high a price for past successes.