Should you Jump on the Social Media Bandwagon?

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

Investing in social media internet stocks has certainly proven to be thrilling. Since their initial public offerings, Facebook (NASDAQ: FB), LinkedIn (NYSE: LNKD), and Zynga (NASDAQ: ZNGA) have challenged investors with volatile, sometimes gut-wrenching price swings. But share prices of all three have recovered, and investors were recently delivered annual reports to digest from all three. The markets seemed pleased with the annual reports of all three. The companies disclosed surprising increases in revenue and active users, and their share prices increased since. The remaining questions for investors are whether these companies are worthy of their lofty valuations and should be scrutinized beyond their user numbers.

Does strong user growth equate to strong companies?

To say that Facebook has been on a wild ride would be an understatement. After perhaps the most closely-watched IPO of all time last year, excitement quickly turned to despair as investors saw the company’s share price collapse from $38 to $17 in four months. Fortunately for investors, the stock has recovered to a current level of $28 on the strength of massive user numbers.

Facebook had 1.06 billion monthly active users at the end of 2012, a 25% annual increase. The market was also encouraged by 57% year-over-year growth in the number of monthly active mobile users. Furthermore, Facebook saw revenue growth of 37% in 2012. Unfortunately, all this didn’t translate into strong profit: the company only earned $0.01 per diluted share in 2012.

Zynga develops online social games, including CityVille, FarmVille, Mafia Wars, and Words with Friends. Revenue was $1.28 billion in 2012, a year-over-year increase of 12%. Diluted EPS was $0.28 for the full year 2012, compared to $1.40 for all of 2011. The company’s monthly active users increased from 240 million in the fourth quarter of 2011 to 298 million in the fourth quarter of 2012, up 24% year-over-year.

LinkedIn is something of a Facebook for professionals. The company’s namesake networking platform allows busy professionals to connect with each other and search for jobs and job applicants. The website boasts more than 200 million members, and the market cheered its full-year results. In 2012, revenue increased 86% to $972.3 million from $522.2 million. Additionally, GAAP-diluted EPS increased to $0.19 from $0.11. 

Have you heard of the price-to-user ratio?

If not, you’re not alone. Valuation still matters. It’s worth noting that despite the strong growth of daily and monthly active users for each of these companies, they have little to brag about in terms of profitability. Facebook and LinkedIn currently change hands for trailing price-to-diluted earnings ratios of 2,800 times and 850 times, respectively. They also trade for price-to-sales ratios in the teens. Zynga, meanwhile, doesn’t have a price-to-earnings ratio, due to the company's reported loss in 2012.

The Foolish takeaway

Facebook’s 10-K lists nine bullet-pointed facts under a section titled ‘2012 Highlights.’ I couldn’t help being disturbed that none of them pertained to anything financial in nature: they all pertained to the company’s growing user base. Such growth is certainly good for these companies, but at some point investors need to see it translate into profitability. The next few sections of Facebook's 10-K describe how the company creates value for users, developers, and marketers. Perhaps it’s time for a new section to explain how the company creates value for shareholders. All three companies have billions in revenue, but year’s end leaves only a few pennies of profit per share. And their web sites’ huge popularity doesn’t reduce the premium investors are paying for shares. Investors shouldn’t stick with these stocks for long if the underlying companies can’t demonstrate clear paths to effective user base monetization.

Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Facebook and LinkedIn. The Motley Fool owns shares of Facebook 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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