Don't Blame Social Media for Crazy Valuations

Warren Buffett is warning about another tech bubble. Last week, at a conference in New Delhi, he said most of today's social-media names would be overpriced when they finally begin trading on public exchanges.

"It's extremely difficult to value social-networking-site companies," Bloomberg quotes the Oracle as saying. "Some will be huge winners, which will make up for the rest."

Fair enough. Facebook notwithstanding, we don't have enough data to value most of the social-media companies that take up headline space. The only reason we know Groupon is worth $6 billion is because that's what Google (Nasdaq: GOOG  ) was willing to pay to acquire the company.

It's also easy to poke fun at social media. Valuing Twitter at $8 billion to $10 billion, or roughly 80 times revenue to enterprise value, is ludicrous when hype-tastic China's Yoku.com (Nasdaq: YOKU  ) trades for 71 times EV-to-revenue and salesforce.com (NYSE: CRM  ) fetches less than 10 times EV-to-revenue.

Still, I think we need to be clear about something. There's no comparing the dot-com delirium unleashed the late '90s to the social-media stampede under way right now. Facebook and Twitter suffer with an active private-equity market that neither Amazon.com (Nasdaq: AMZN  ) nor eBay (Nasdaq: EBAY  ) had to contend with.

Getting to IPO was also easier. Jeff Bezos founded Amazon in 1994 and took the company public in May of 1997. Mark Zuckerberg, Eduardo Saverin, Dustin Moskovitz, and Chris Hughes co-founded Facebook in 2004. Seven years later, we're still waiting for a public offering.

So while Buffett and others are right to question valuations for some of social media's rising stars, we can't just leave it there. As investors, we need to understand why prices are rising fast. The simple answer is that Big Money has entered the game.

And that's largely due to the rise of private-equity exchanges such as SharesPost and Second Market. Each promises to match pre-IPO owners of stock with institutional and accredited individual buyers at a negotiated price, and then take a transaction fee.

Think of it as an auction, with the winning bidder winning shares. Prices can vary widely as a result. On SharesPost, Facebook's implied valuation has fluctuated between $68 billion and $83.9 billion since Feb. 14. The last completed transaction valued the business at $79.3 billion. Does anyone consider these real valuations?

I don't, if only because they're fueled entirely by what any single investor is willing to bid for shares out of a limited pool of participants. The most recent estimates say there are only 5 million to 7.2 million American adults who meet the qualifications necessary to invest in private equity, a designation known as "accredited investor."

Regulations therefore guarantee that private-equity markets be illiquid. SharesPost and Second Market improve the situation somewhat, but add one big institution with deep pockets, and you have a market based on what the biggest players can afford.

Who's using these exchanges and how much money they're putting in is unknown at this point. But we do know that limited-liability companies have been created solely for the purpose of investing in the hottest names on the Social Web. JPMorgan Chase (NYSE: JPM  ) has also announced a fund for investing in social media.

In short, this "new" private-equity system is beginning to look a lot like Major League Baseball, with Facebook as the industry's Alex Rodriguez. To the rich go the spoils. Now do you see why social-media valuations have gone nuts?

It's not that common investors are failing at fifth-grade math or confusing tweets for revenue. It's that private-equity investors are displaying an insatiable appetite for social media inside markets that don't balance supply and demand nearly as well as the public markets do. Call that unfair or even moronic if you like. But as bubbles go, this one's a lot less dangerous than the ones that preceded it.

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Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He owned shares of Google at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Google and JPMorgan Chase. The Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is crazy. Like a fox, that is.


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  • Report this Comment On March 28, 2011, at 8:43 PM, TMFTheDoctor wrote:

    While I agree that individual investors aren't the crazy ones here, it does still seem like the institutionals are falling into the old irrational exuberance. Either way though, I'll certainly be interested to see how the LinkedIn IPO goes in a few weeks.

  • Report this Comment On March 28, 2011, at 9:26 PM, jayvon1 wrote:

    Why do they only report on the TBTF banks? IBCP just increased it’s dividend to 6% that’s a great upturn compared to some of the other banks dividend of a penny. Independent Bank (NasdaqGS: IBCP) is currently rated as one of the top Banks in the Regional Banking Industry based on estimated Forward Earnings. If you look at the projected earnings for the current fiscal year Independent Bank (NasdaqGS: IBCP) has the highest forward earnings yield in the Regional Banks Industry at 35.2%. The forwards earnings yield is often useful to compare the performance of a stock's return versus owning a stock within the same industry or other yield-based assets such as bonds

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