Should You Buy Social Media Stocks?

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

Facebook (NASDAQ: FB) shares exploded to the upside on July 25 after reporting excellent quarterly earnings, redeeming those who stuck by the social network since the company’s famously disappointing initial public offering.

Social media stocks, including peers LinkedIn (NYSE: LNKD) and Yelp (NYSE: YELP), have been on fire over the past few months. There seems to be no end to either the amount of investor optimism surrounding these companies, or the valuation multiples investors are willing to pay for the privilege of ownership of these stocks.

While it’s undoubtedly true that Facebook just wrapped up a great quarter with strong growth in nearly all the metrics that are important to the company, in my estimation, the stock’s valuation and growth expectations are beyond reasonable levels.

A social media bubble?

After perhaps the most closely watched IPO of all time last year, the excitement surrounding Facebook quickly turned to despair. Investors saw the company’s share price collapse from $38 to $17 in four months.

Fortunately for investors, the stock had already recovered very strongly leading into earnings, and shares continued to soar after releasing its quarterly results. In all, Facebook stock skyrocketed around 30% on the day following its earnings announcement.

That’s because the company unleashed a huge quarter, with earnings of $0.19 per share, beating expectations by a nickel and easily topping last year’s $0.12 per share in second-quarter 2012 profits.

Revenue grew 53% year over year, to $1.81 billion, far exceeding analyst estimates, which called for $1.62 billion.

Broad optimism was also fueled by the company’s successful transition to mobile. In the second quarter, 41% of advertising revenue was from mobile, up 11 percentage points quarter over quarter. Again, this metric blew past expectations.

LinkedIn, something of a Facebook for professionals, exchanged hands for $93 per share after its heavily publicized 2011 initial public offering. Since then, the stock has gone on a nearly uninterrupted run to $200 per share.

Along the way, LinkedIn has piled up active users, and as a result, revenue. As of the company’s last quarterly results, the website boasted more than 225 million members. Moreover, LinkedIn booked 72% revenue growth in the first quarter, year over year.

LinkedIn also generated huge growth in full-year 2012, with revenues and diluted EPS skyrocketing 86% and 72%, respectively.

Yelp, meanwhile, has seen its share price soar beyond even the most generous expectations. I last wrote about Yelp, the online guide for information and reviews of popular places of interest, in April. At that time, Yelp exchanged hands for $25 per share, exactly where it ended its first day of trading when it went public last year.

Shares took off since I last wrote about Yelp, breaching $40 per share recently. Yelp’s meteoric rise is particularly perplexing, given the company’s inability to turn a profit. Yelp reported losses in fiscal 2012 as well as the first quarter of 2013.

Growth at an Unreasonable Price

In investing, there’s a strategy known as GARP, which stands for growth at a reasonable price. In short, it relates to growth investors who look for companies showing strong underlying growth in revenue and profits whose shares still trade for reasonable multiples.

That last statement contains two important pieces: demonstrable growth, and a reasonable valuation. I believe Facebook has the former; the latter, however, just isn’t there.

Facebook earned one penny per share last year and $0.46 per share the year prior. Obviously a stock that earns one penny per share will have a ridiculous P/E. But, even on a forward basis, the valuation is lofty: Facebook trades for a forward P/E of nearly 50 times.

As far as LinkedIn is concerned, the company amassed a grand total of $0.19 per share in diluted earnings last year. That means that investors are paying more than 1,000 times 2012 earnings.

Like Facebook, LinkedIn and Yelp are both aggressively valued, even when you take strong future growth into account. LinkedIn and Yelp trade for forward P/E multiples of 90 and 230 times, respectively.

To be clear, I absolutely recognize the strong growth each of these companies is realizing currently. At the same time, valuations have risen so far, so fast, that even when assuming huge growth rates going forward, the odds of shareholders winning over the long-term aren’t in the investor’s favor.

These web sites undoubtedly have hundreds of millions of satisfied users and loyal fans. And, I can’t possibly say for certain that social media is the next bubble waiting to burst. What I will suggest, however, is that these stocks are not nearly profitable enough to justify the massive valuations they enjoy.

Facebook is now an $80 billion company by market capitalization. It’s rarely advisable to pay 50 times forward earnings for such a large company. These social media stocks are simply too risky for prudent long-term investors.

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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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