The social media company Twitter (ticker symbol: TWTR) announced yesterday that first quarter revenue grew less than expected and told investors to expect lower sales growth in the near future as well.  As a result, the stock was down almost -20 percent in late trading.

When I first saw the headlines, my immediate thought was, ‘this is why you don’t buy growth stocks – when they disappoint on growth or earnings, it’s very costly for shareholders.’

Of course, we don’t care too much about TWTR because it’s not on our Approved List and, as far as I can tell, no clients own the stock.

I thought it was worth talking about, though, because I’m prohibited from talking about stocks we own and am free to talk about stocks that we don’t own.  By talking about what we don’t do and why with a real live company, I may be able to communicate what we actually do and why.

Let’s start with the basic business model.  Personally, I think the entire medium is stupid, but maybe that’s because I can’t get out of bed in 140 characters.  (That paragraph was 131 characters).

No matter what I think, though, 288 million monthly users seem to like it and the vastness of the platform gives it a lot of value because of something called ‘the network effect.

The easiest way to describe the network effect is by example.  The telephone wasn’t valuable to Alexander Graham Bell until he told his assistant, ‘Mr. Watson – come in here – I want to see you’ on March 10, 1876.

Bell needed at least one other user to make the phone valuable.  It was even more practical when there were 10 people with phones, then 100 and 1,000 until everyone had a phone.  The more users there were, the more valuable it became.

Despite having a strong network effect in place, Twitter is surprisingly unprofitable.  Last year, the company lost $578 million on $1.4 billion in revenues.

That’s somewhat forgivable for a new company, though, because they are plowing money into their technology and trying to solidify their competitive advantage.

When we evaluate a company’s profitability, we actually give close consideration to a company’s gross profits, the revenue minus the cost of goods sold, for exactly this reason.

The gross profits tell you a lot about the economics of the basic business and help you look beyond some of the noise that may be affecting the bottom line. (I will be covering this in more detail when I do my ‘profitability’ primer).

In Twitter’s case, they aren’t that profitable on this measure either.  If you divide their gross profits of $957 million over their total assets of $5.6 billion, you only get a ratio of 0.17.

That ratio probably doesn’t mean much to you, but academic studies show that, on average, you want gross profits to be at least 0.35 percent of assets, which for Twitter, would translate into $1.96 billion in gross profits, putting them about $1 billion behind the eight ball.

If the stock were cheap enough, you might be able to look past the poor profitability, but Twitter is hardly cheap.  There is no price-earnings ratio because there are no earnings – they’re losing money, remember?  The price-to-book ratio is 9.2, compared to 2.8 for the S&P 500.

Price to sales and cash-flow measures are even more nuts at 22.3 and 382.1 times respectively.

Twitter bulls will tell you that it’s okay to pay that much for the stock because it will grow so much in the future.

Morningstar did a discounted-cash-flow (DCF) of Twitter that incorporates growth estimates and thinks that the stock is worth $43 per share, which is pretty close to the final price yesterday of 42.27 after falling 20 percent.  Still, that’s fair value – not cheap.

But that’s the problem with hot growth stocks like Twitter.  As an investor you desperately need growth to justify the valuation and when there’s a hiccup, like there was yesterday, the downside can be steep.

With all that said, though, Twitter may turn out to be a wonderful investment.  I pooh-poohed Google when it first came out for being too expensive.  They delivered the growth, the stock boomed and I had egg on my face.

It’s impossible to say what will happen, but we’re not attracted to high fliers like this.  While we would love to own a stock with a strong network effect like Twitter, we also want the company to be highly profitable and buy it at a reasonable price – no easy feat.