Are These Web 2.0 Stocks Being Overvalued?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Most web 2.0 stocks are problematic for two reasons. They often trade at prices which are beyond reasonable price multiples. They are also risky, since they pioneer new business models which may not be great for investors in the long-term. As weird at this sounds, investors are trading many of these stocks at premiums to take unsubstantiated risks.

Investors considering these stocks should actually be very concerned by valuations. At today’s market prices which, if any, of these web 2.0 stocks are attractive?

Facebook Search Tool

Facebook (NASDAQ: FB) recently introduced “Graph Search,” a new service for searching information from data contained in its social network of over one billion users, offering an alternative to Google (NASDAQ: GOOG)LinkedIn (NYSE: LNKD) and Yelp (NYSE: YELP) search services.

Facebook CEO Mark Zuckerberg said, “Graph Search is designed to take a precise query and return to you the answer, not links to other places.” The company showed how it can be helpful to recruiters and users looking for dating partners, but Zuckerberg failed to outline how it will make money, frustrating investors seeking to generate income in the future. IDC Analyst Karsten Weide estimates that Facebook can grab 5% of the United States' $15 billion search-advertising market should it introduce advertising on the search results.

Lars Rasmussen and Tom Stocky, respective Directors of Engineering and Product Management who formerly worked at Google, are the two key employees responsible for the new search tool. 

For now, Graph Search is only available in English to those who signed up for beta testing.  Through a partnership with Microsoft, Bing search engine results from the Web will be included if Graph Search fails to deliver clear answers.  Unlike current search engines, Graph Search allows users to combine phrases to sift information from data shared on the network; however, privacy was built “deeply” into the service, according to Zuckerberg.

As the user enters a query in the search box, the service suggests potential searches. Results, including people, photos and places of interest, can be customized to specific search parameters, such as location, time frame and other information contained in profiles. The feature will eventually be available in other languages and mobile devices.  Facebook also plans to include information from user posts and other online services connected to it.

In addition to Facebook, many recruiters and job candidates are finding each other on LinkedIn. LinkedIn allows headhunters to search from over 187 million profiles of potential employees. The company recently added the talent pipeline feature that allows the recruiters to keep track of their candidates. More than half of the total revenue of the company in 2012 came from the online recruitment division.

Companies are seeking ways to discover talent that is hidden in most job search engines. Elliot Garms said, “No good software engineer puts his resume on Monster Worldwide, because then they get 10 to 20 emails a day from recruiters.” According to Tom Chevalier, “Monster has evolved far beyond the traditional job board model.”

Key People Leaving Zynga

David Wehner left his CFO role at Zynga (NASDAQ: ZNGA) to join Facebook as vice president of corporate finance and business planning. He is one eight other senior managers to leave Zynga since August. Analysts are concerned. According to Arvind Bhatia, “When executives start voting with their feet it sends a more powerful message than anything the company can say. It seems more and more that the company is going to have continued issues.”

Zynga has changed its strategy by embarking on cost-cutting and boosting revenue from games on mobile devices. It is cutting 5 percent of staff, ending more than a dozen titles and shutting offices as a result.

Heed Valuation

Since the price you pay is the denominator of stock returns, anyone who says price doesn’t matter is not worth listening to. Given the troubles facing Zynga and Groupon, these stocks should be priced so that their valuation multiples are clear bargains relative to market averages. Other social media stocks should be priced competitively to the broader market.

The price multiples for these stocks are wildly different:

<table> <tbody> <tr> <td> <p><strong><span>Ticker</span></strong></p> </td> <td> <p><strong><span>Company</span></strong></p> </td> <td> <p><strong><span>P/E</span></strong></p> </td> <td> <p><strong><span>P/S</span></strong></p> </td> <td> <p><strong><span>P/B</span></strong></p> </td> <td> <p><strong><span>P/FCF</span></strong></p> </td> </tr> <tr> <td> <p><span>FB</span></p> </td> <td> <p><span>Facebook</span></p> </td> <td> <p><span>269.64</span></p> </td> <td> <p><span>13.86</span></p> </td> <td> <p><span>4.54</span></p> </td> <td> <p><span>293.41</span></p> </td> </tr> <tr> <td> <p><span>YELP</span></p> </td> <td> <p><span>Yelp</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>10.59</span></p> </td> <td> <p><span>8.86</span></p> </td> <td> <p><span>NA</span></p> </td> </tr> <tr> <td> <p><span>LNKD</span></p> </td> <td> <p><span>LinkedIn</span></p> </td> <td> <p><span>793.47</span></p> </td> <td> <p><span>15.29</span></p> </td> <td> <p><span>15.4</span></p> </td> <td> <p><span>280.82</span></p> </td> </tr> <tr> <td> <p><span>ZNGA</span></p> </td> <td> <p><span>Zynga</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>1.5</span></p> </td> <td> <p><span>1.03</span></p> </td> <td> <p><span>NA</span></p> </td> </tr> <tr> <td> <p><span>GOOG</span></p> </td> <td> <p><span>Google</span></p> </td> <td> <p><span>22.07</span></p> </td> <td> <p><span>4.87</span></p> </td> <td> <p><span>3.4</span></p> </td> <td> <p><span>18.27</span></p> </td> </tr> </tbody> </table>

Zynga is cheaper than the rest of these stocks. It is trading near the book value of its equity, a steal for a tech stock since many of its assets are not recorded on the balance sheet. Like Yelp, Zynga did not generate profits over the last year, making a price-to-earnings multiple incalculable.

In contrast, LinkedIn is just too pricey. Shares trade at a price-to-book ratio of 15.4, so there is no argument for cheapness based on its balance sheet. Its price-to-earnings multiple is astronomical and its price-to-sales multiple is about ten times higher than the market average.

Facebook’s price multiples are similarly scary. Facebook stock trades at a a price-to-earnings multiple of 269.64, and a price-to-sales multiple of 13.86. As was the case for LinkedIn, these are just too high.

Google is valued in between the cheap multiples of Zynga and the expensive multiples of Facebook and LinkedIn. It is still pricey, but not ridiculous.

Wait for Deals

Facebook and LinkedIn are just too expensive at current price multiples. Zynga is cheap, but it is a speculative bet. Investors who want to take on risks should consider Zynga, but should wait for other players in the search and web 2.0 spaces.

BillEdson11 has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google, and LinkedIn. The Motley Fool owns shares of Google and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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