The Social Media Bubble (aka The Facebook Bubble)

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By Jesse Colombo

(This article was written in January 2012, before the disastrous Facebook IPO. Many of the predictions in this article have come true since then. Please read my addendum article where I discuss how the social media bubble has unfolded so far.)

Abundant hype, wildly overvalued IPOs, overnight millionaires, questionable business models, scores of startups offering gimmicky and frivolous services, the social media bubble has it all – it’s a dream come true for Generation Y techies and investors who missed out on the Dot-com bubble or for those folks who simply feel nostalgic for the heady days of the late 90s.

Social Media Bubble: LogosThe social media boom has its roots in the relatively recent successes of a leading new wave of tech companies (and acquired startups) such as Google, Youtube, Apple, Facebook, Groupon, LinkedIn and Twitter. Successful early employees and investors of Google and Facebook have become venture capitalists looking to find and invest in “The Next Facebook.”

There’s nothing inherently wrong with social media or social media companies per se; what has become a bubble is the level of hype and mania surrounding social media startups, IPOs and, most importantly, the wild valuations that investors are eagerly paying for these companies. Social media has become the latest in a long line of investment fads. (Remember solar and alternative energy stocks in late 2007? That didn’t end very well.)

How the Social Media Bubble is Like the Dot-com Bubble

During the peak of the late 90s tech mania, before the crash, the Price/Earnings ratio of the Nasdaq 100 was far over 200 (a healthy level is 20 or less). A high Price/Earnings ratio is a sign that investors are willing to pay very high prices for a stock due to their expectations of blazingly high earnings growth.Social Media Bubble: Dot-com Image

The social media bubble is certainly trying its very best to beat the Dot-com bubble, in terms of insane valuations:

LinkedIn sports a whopping near-1000 P/E ratio. Facebook is planning an early 2012 IPO that would value it at a cool $100+ billion on about $4 billion annual revenue (while their earnings are a mystery number). When this IPO materializes, Facebook would be worth more than Silicon Valley bellwether, Cisco, which is pulling in over $43 billion in annual revenue. Groupon IPO’d in early November 2011 at a P/E ratio of 107, using 2012 forward earnings projections because its 2011 earnings are negative. Even notorious stock booster Jim Cramer called Groupon an “Engineered” IPO that should be flipped immediately after the IPO. There are even some analysts who argue that Groupon’s business model is structured like a Ponzi scheme.

Pandora web radio IPO’d in Spring 2011 with negative earnings, giving it an incalculable P/E ratio. We’re seeing the same exact mistakes made in the Dotcom bubble. A tech analyst calls Pandora “dramatically overvalued.”

Social Media Bubble: Zynga's Farmville GameZynga, maker of popular Facebook games like Farmville and Cityville, launched a December 2011 IPO that valued it at $7 billion, with a P/E ratio (2011 earnings) of approximately 175. This is a very lofty price to pay for a company with rapidly decelerating growth and with “earnings” that may only exist thanks to accounting tricks. At the end of the day, Zynga is just another gaming company and is strongly overvalued compared to its industry peers.

The wild valuations carried by these more well-known social media companies sets the tone for the rest of the sector’s valuations. High valuations like these means that the wealth of social media company founders and investors is largely based on hype and hope rather than on solid economics; they are far wealthier than founders of other businesses that have identical earnings but more realistic valuations.

Whether based on hype or solid economics, sky-high social media company valuations provide a powerful incentive for entrepreneurs and venture capitalists to create startups and cash-in big, despite having little or no earnings.

The Social Media Bubble is Fueled by Hype

Social media profits (and hopes of profits) are leading to signs of exuberance everywhere in Silicon Valley: Tesla Roadsters, houses priced for Mark Zuckerberg and demand for $40 a teaspoon vinegar. Silicon Valley luxury retailers are expecting a huge bump in business from the new crop of internet millionaires. IPOs are reinflating the already exorbitantly-priced San Francisco housing market.

Social Media Bubble: Mark ZuckerbergWhen 25-year old Facebook founder Mark Zuckerberg was Time Magazine’s 2010 “Man Of The Year,” some viewed it as a bad omen for the social media boom, recalling how Amazon founder Jeff Bezos was Time’s “Man of the Year” in 1999, practically marking the top of the Dotcom Bubble. Mark Zuckerberg’s fame and success has created a generation of “Zuckerberg Wannabees,” some as young as 13 and a surge in the number of college computer science majors. It’s no surprise that computer science is glamorous again when 21 year olds sell their social networking startups for $100 million and there are now 15 new startups with $100 million+ valuations that hardly existed one year ago and 20 year old tech venture capitalists in Silicon Valley.

With what seems like everybody and their cousin trying to launch a social media or an “app” startup, the number of startup incubators has more than tripled since 2009. Some analysts believe there is an incubator bubble as well. Sean Parker, Napster founder, successful tech VC and early Facebook investor, believes that Silicon Valley is in big bubble trouble due to “too many angel investors throwing way too much money….at aspiring entrepreneurs who aren’t up to the task of building a company.”

Why the Social Media Bubble Will Pop

It’s very possible that some social media company founders and venture capitalists are keenly aware of the sector’s bubble and intend “flip” shares at wild valuations as long as the frenzy is still alive. One thing is for sure, savvy tech founders are voting with their pocketbooks as they cash out very large quantities of their shares. These insiders’ actions are not exactly confidence-inspiring for any potential long-term social media investor.Social Media Bubble Image

In the end, you can’t help but note the overall frivolity of the social media phenomenon, especially in such grave economic times. Many aspects of the social media boom simply aren’t genuinely useful to society, the way a boom in biotechnology or alternative energy would be. Additionally, the vast majority of social media company business models consist of monetizing their web traffic with advertising. It’s hard to get very excited by businesses that rely solely on the health of consumers in an age of stubborn near-10% unemployment, falling salaries and crushing levels of personal debt. Facebook, Twitter and the like are clearly here to stay, but the unrealistically high valuations, the mania to create gimmicky “me-too” app startups and to invest in highly speculative social media IPOs is where the bubble lies.

Links to Social Media Bubble (aka The Facebook Bubble)-Related Articles

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