Social media is a big business. The combined market cap of the industry’s three biggest players, Facebook (FB), LinkedIn (LNKD), and Twitter (TWTR) is over $160 billion, which would make them bigger than Citigroup (C), BP (BP), or Verizon (VZ) . And that doesn’t even factor in Google (GOOG) which, while not a pure social media play, has a significant entry into the segment with YouTube and GooglePlus.
This current market for social media stocks must have been firmly in mind for Snapchat’s Evan Spiegel when he and the other company founders spurned purchase offers of up to $4 billion. That valuation left traditional value investors sputtering with rage.
But here’s the thing, if you’re skeptical about Snapchat being worth that much, and you’re not alone, what does that mean about the valuation of the rest of social media as an industry? Snapchat, based on the going rate for social media users at the moment, is absolutely worth $4 billion. And if it’s not, all of that $160 billion is potentially way out of line.
So are we in the midst of a social media bubble? Facebook, at this point the grande dame of social media, was founded just over nine years ago. And one need only look back to the 1990s and the dot-com bubble to see an industry that rose rapidly only to hit a wall when the markets started to balked at continuing to throw money at companies failing to produce earnings.
So, is Snapchat overvalued? And, if it is, doesn’t that really mean all social media companies are overvalued?
One doesn’t exactly have to be an expert in the nuances of fundamental analysis and value investing to start poking holes in the share price being paid for the industry leaders at the moment. Facebook currently sports a P/E ratio of 97.68, LinkedIn is at 720.33, and Twitter…well Twitter has never had any actual earnings, so it’s impossible to know for sure.
If investors were to pay same premium on each dollar of earnings for shares of, say, IBM (IBM) , as investors are currently paying for Facebook, IBM would have a market cap of $1.5 trillion. Yes, trillion with a T. Not a typo. Do the same for LinkedIn and that number shoots up $11.3 trillion. Or, you know, five times the GDP of Brazil. And IBM has a dividend, in case you were wondering.
Now the comparison to IBM is far from fair. The companies are in different stages of their development, with IBM being an established blue-chip with nearly a century of history and limited earnings growth, not to mention operating in completely different industries.
Priceline.com (PCLN), however, may be a more apt comparison as they’re both relatively young (Priceline.com was founded in 1997) and both internet companies. Priceline.com currently sports a market cap of $60.5 billion, a bit under half of Facebook’s $113.8 billion. But a quick glimpse at their financial statements shows that in 2012, Facebook’s $5.1 billion in revenue was actually below Priceline.com’s $5.3 billion. So with equivalent revenues, why pay double for Facebook?
Paying for Growth
The short answer is that investors are paying for earnings growth. Facebook’s gross profits for 2012 may have been just $3.7 billion, but that represented a 30.7 percent increase over 2011, and a 151.5 percent increase over 2010. Compare that to Priceline’s growth of 20 percent and 70 percent respectively. For IBM? That’s 0.3 percent and 9.3 percent respectively. Facebook's also reinvesting a significant portion of those profits into the company, expanding its reach and improving its ability to monetize users, which skews earnings numbers significantly when comparing it to an established company like IBM.
Still, nowhere else in the market can one find that sort of explosive earnings growth, and that’s precisely why investors are willing to pay $100 or $700 for every dollar of earnings they’re getting in return. IBM may be a relative bargain with a dividend to boot, but you can also be pretty sure that, even in the best case scenario, its growth isn’t going to reach levels even approaching that of a hot new social media company.
Can Facebook, LinkedIn, and Twitter Ever Justify Valuations?
Of course, at some point, the rubber meets the road and these companies are going to need to sustain earnings growth until they’re producing profits that justify the valuations. Facebook may be making revenues approximately the same as Priceline, but it’s going to need to double that before its valuation starts to fall into a more reasonable range.
And that's child's play compared to the mountain LinkedIn has to climb to justify its share price. IBM may not have the same potential for growth, but it is a proven performer many times over. So is Priceline, at this point. And, at some point, social media's potential will have to stop being speculative and start becoming real.
And that’s where things start to become largely speculative. Facebook has already come a pretty long way to get to where it is now. Can it really double its revenue from this point? And that would just be to get its P/E ratio under 50, which would mean it would still have the highest P/E ratio of the 25 most valuable tech companies in the world save Verizon (P/E ratio of 65.12). Even factoring in that explosive growth, there's plenty of room for skepticism.
What are Social Media Users Worth?
Facebook currently has about 1.2 billion users, good for almost 1 out of every 6 people on the planet. As such, Facebook’s ability to expand its user base appears relatively limited moving forward. That’s why the company’s focus is on increasing revenue on a per-user basis. And Facebook leads the social media crowd in that regard, with more than $1.70 in revenue per user in its last quarter, compared to just over $0.70 per user for Twitter.
Clearly, any number of investors believe that Facebook and company can nearly double per-user revenues for their platforms, and Facebook isn't short on ideas for how it can get there.. For instance, the company's announced plans to sell targeted 15-second video ads on its site for between $1 million and $2.5 million a day, something that could easily represent a major new revenue stream.
However, it’s worth noting that Facebook is already squeezing more ad revenue out of each user than any social media platform in history (not that that's really saying all that much). Can it double that? Possibly. But possibly not. This is all pretty new territory, and it’s not an impossible thought that there’s a ceiling to the amount of money per user that a social media site can expect to rake in. And Snapchat may be the key to understanding the potential limitations to this market.
Ad Rates and Teens: What are Two Things that are Hard to Pin Down?
Part of what was so baffling to many people about Snapchat’s rise from relative obscurity to being a company worth (presumably) more than $4 billion was the rate of its rise. The company was founded a mere two and a half years ago and it’s already worth how much? But when savvy tech investors looked at Snapchat, they saw a user base of 30 million that’s rapidly expanding and sharing 400 million “snaps” a day. What’s more, most of those users fall into the valuable 13-25 demographic.
Ad revenues are based on the rate that advertisers are willing to pay for those ads. And that rate reflects the value companies believe they’re getting from the ads. Ads on Snapchat, with its high usage rate and young users, should theoretically be worth a lot, driving the belief that the company could be worth that much.
But this also assumes that these user-bases won’t erode over time. As a generation of children starts coming of age in an era where their parents are not only on Facebook, but were on Facebook before them, it’s entirely possible that the aura of cool Facebook rode to its current dominant state will evaporate (assuming it hasn’t already). Facebook executives have already acknowledged that user-growth among teens is starting to lag, and the explosive growth for Snapchat, less then 24 months after Facebook shelled out $1 billion to grab Instagram, could be viewed as a sign that social media may have a distinctly cyclical nature we're only just beginning to understand.
It's easy to dismiss, but it's also impossible to be sure of anything with an industry that has no real history to fall back on when judging trends.
How Much Permanence Really Exists in Social Media?
So what if that’s true? What if the nature of social media is a new, hot platform rising every few years and stealing away young users from the previous new, hot platform? In its early days, Facebook stole users from MySpace and Friendster, two companies that have disappeared from view over the years. Everything about the valuations of social media companies is based on projected growth.
But what if a glut of new competition every few years means that contraction is actually more likely? Suddenly paying that premium for Facebook's earnings doesn't seem like such a good idea.
Certainly, Facebook is probably around to stay. But if it’s headed for a smaller, older audience than it has currently, it’s less valuable to advertisers in the long run, not more. And if new platforms keep popping up to challenge Facebook’s relative supremacy, it will only compound the problem.
Also, the question of whether or not the ads themselves are, at least in part, what's driving away young users is one that needs to be asked before the long-term value of social media companies can be settled. Facebook or Twitter may anticipate being able to offer more advertising options to improve per-user revenue, but what if cramming their platform full of promoted posts and 15-second spots results in fewer users and less engagement from the ones that remain?
Thus far, both platforms seem to have dodged that bullet, but will that continue to be the case if they constantly have to keep fighting off a new slate of competitors year after year? When Facebook bought Instagram, many industry experts described it as largely a defensive move. Does that mean established social media platforms will have to keep paying a premium to buy out new companies just to protect the user-base they've already carved out? If that's the case, doesn't that cut into some of the projected growth that social media investors are currently banking on?
No Sure Thing
In the end, there’s no way of knowing for sure if social media companies really warrant their current sky-high valuations. Certainly, plenty of room for healthy skepticism exists. But, at the same time, it’s entirely possible that current projections for potential revenue are way too low. The unavoidable fact at this juncture is that the industry is too young for any projections to carry total confidence.
What’s more, even if the segment is due for a day of reckoning like the bursting of the dot-com bubble, that doesn’t mean that there isn’t real value present. Internet companies, on the whole, were clearly overvalued in 1999, but that doesn’t change that fact that some, like Google, were still excellent investments to make, even when paying a huge premium on earnings.
Only time will tell if Facebook, Twitter, or LinkedIn are really worth what investors are paying for them. But if the rapid rise of Instagram and Snapchat prove, in the long term, to be the nature of the industry, it seems entirely possible that social media investors are due for a rude awakening before all is said and done.
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