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Is it Time to Buy Social Media Based Companies

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

In case you missed it, LinkedIn (NYSE: LNKD) traded higher by more than 21% last Friday, and led other stocks higher, as it crushed earnings expectations. The stock is now sporting a “dot-com like” valuation, but has strong growth that has remained stable. With that being said, there are a lot of people who believe that now is the time to buy social media stocks; but is it?

A Look at Valuation

The P/E ratio for the S&P 500 is almost 15.0, and the ratio for the technology sector is surprisingly consistent with the S&P 500. I say surprisingly, because most believe that tech has the highest P/E ratio in the market due to the sector’s strong performance over the last year. However, it’s nothing compared to that of the telecom space, a sector that trades at nearly 22 times earnings (thanks in part to the iPhone and subsidiaries).

When you consider that technology is consistent with the S&P in terms of value, you start to realize just how great the distinction within technology is in how companies are valued. Most social media companies trade in this sector, and have gaudy valuations. For example, after LinkedIn’s quarter, it now trades with a P/E ratio of 800 and a price/sales ratio of more than 16.50! These are insane metrics, and are only appropriate for companies that could experience multiple years of explosive growth. Therefore, we must take growth into the equation. With that being said, let’s look at the social media internet based companies that increased in value thanks to LinkedIn’s earnings to determine if any are worth buying.

  • LinkedIn is the company that created the movement with its revenue growth of more than 80% and its EPS that more than doubled expectations. Looking ahead, the stock is trading with a forward P/E ratio of 77 and a future price/sales of 11.51 based on full-year guidance. The P/E ratio represents a vast improvement in margins, but in my opinion the future price/sales is too expensive. The company is growing fast, but not fast enough to account for such a crazy valuation. With that being said, it could trade a little higher in this upcoming week due to momentum, yet it still looks like a prime short candidate.
  • Yelp (NYSE: YELP) rose 2.34% on Friday after LinkedIn’s earnings, recovering some of its losses from when it issued lower-than-expected guidance. This is a company that is already seeing slowed growth, with top-line growth of about 40% expected in 2013. The stock has a future price/sales of 6.57 but is still expected to experience margin trouble in the year ahead. As a result, I don’t see any value in this stock and believe it to be a value trap.
  • Despite Groupon’s (NASDAQ: GRPN) trouble over the last year, the stock is the cheapest in the space. It trades with a future price/sales of under 1.50 and a forward P/E ratio of 22.62. These are numbers that are consistent with other companies in technology, and therefore, Groupon might actually make a good investment if it can achieve revenue growth in 2013.
  • Zynga (NASDAQ: ZNGA) is another cheap stock in the social media space; one that rose 11% on Friday in part due to LinkedIn’s earnings, speculation regarding online gambling, and also a continued rally from its earnings. The company trades with a price/sales ratio 1.90, but could see flat or declining growth in 2013. Therefore, from a valuation point-of-view the stock is cheap but fundamentally there are a lot of questions.

When you invest in a social media stock you are typically paying a higher premium to own part of a company that may or may not last. Throughout history we’ve learned that companies with business models based on the internet, that don’t offer an actual product, have a tendency to fade when the next cool thing emerges. Therefore, I view these stocks with as much risk as a Phase 2 biotechnology stock.

Personally, I wouldn’t touch LinkedIn or Yelp, two companies with business models based on jobs and reviews; how large could they become? In this particular list, Groupon and Zynga look to be the best, and in the coupon and gaming spaces, there is far less competition in the social media industry. The bottom line is that although investors are feeling optimistic following LinkedIn’s strong quarter, these are very expensive stocks that could come crashing down even faster. Therefore, be careful!

BrianNichols has no position in any stocks mentioned. The Motley Fool recommends LinkedIn. The Motley Fool owns shares of 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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