Wall Street's Newest Bubble

Wow. That was my initial reaction back in January to Goldman Sachs' (NYSE: GS  ) $450 million investment in Facebook, which implied a $50 billion market valuation for the popular social-networking site. When a follow-up investment last week established a new $65 billion valuation, my response had a slightly more McEnroeian bent: You cannot be serious!

In less than 10 years in existence, Facebook's market value has surpassed that of iconic corporate giants such as Boeing (NYSE: BA  ) , Honeywell (NYSE: HON  ) , Kraft (NYSE: KFT  ) , and Nike (NYSE: NKE  ) .

Company

Market Cap

12-Month Revenue

12-Month Free Cash Flow

Facebook (estimated) $65 billion $2 billion ??
Boeing $54 billion $64 billion $1.8 billion
Honeywell $47 billion $33 billion $3.6 billion
Kraft $55 billion $49 billion $2.1 billion
Nike $36 billion $20 billion $2.1 billion

Each company generates tens of billions in annual sales and has almost impenetrable competitive advantages built from decades upon decades of growth. More importantly, these companies will be here tomorrow, next month, next year, and in the next decade -- still producing great products, expanding into new markets, and churning out loads of free cash flow.

Facebook ... well, it has a "poke" feature.

A social-networking bubble?
And it's not just Facebook. An investment in Twitter by JPMorgan Chase (NYSE: JPM  ) last month valued the 5-year-old social microblogger around $4.5 billion. Popular job networking site LinkedIn recently filed for an initial public offering that values it around $2.5 billion. (Through the first nine months of 2010, LinkedIn reportedly generated a mere $10 million in profits.) And then there's the rumored $10 billion valuation for Zynga, the social-gaming company responsible for the megahit Farmville, and Groupon, the popular deal-of-the-day website, which some have valued in the $15 billion to $20 billion range.

I don't know about you, but these valuations seem a tad bit outlandish to me. Today's zeal for social-networking sites harkens right back to those bubbly dot-com boom days from the late '90s. You remember those, right? Wall Street made billions on IPOs of profitless technology and dot-com companies. Remember Pets.com? How about Webvan? One of the most egregious in my opinion: VA Linux Systems. Check out this language from the "Internet infrastructure" company's 1999 IPO prospectus:

We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.

Classic, right? Well, that language wasn't enough to dissuade investors from driving shares of the company up 700% on their first day of trading to a high of $320 per share, awarding Linux with an incomprehensible market cap of nearly $13 billion! Not bad for a company that didn't expect to generate any meaningful profits in the foreseeable future.

A short time later, in July 2002, shares of VA Linux traded hands at $0.54.

Many individual investors bought the hype that Wall Street was selling and were left holding the bag when the dot-com bubble burst. No matter for Wall Street. By then, it was well on its way to its next money-making, er, losing, gig: subprime mortgages. We all know how that story ended.

Don't chase the hype
There's going to be some huge winners in the social-networking space, no question. But attempting to pick the ultimate winners in an industry with extremely low barriers to entry will be an exercise in futility. Individual investors who blindly chase after these stocks following their IPOs are taking the same risks their dot-com-chasing counterparts took more than a decade ago. In most cases, it will lead to damaged portfolios and more than a few tears.

When asked in a recent interview on CNBC why he doesn't invest in some of the faster-growing technology names, Warren Buffett responded:

I understand things that happened in the past and which ones are likely to repeat and which ones are hula hoops or pet rocks. I can make those decisions reasonably well. I am not good at listening to 20 guys who've got great new ideas about things that are going to change the future.

Investing in the past may not be as glamorous as betting on what could be the next Facebook, but in our view, it's a much more prudent way to profit in the future.

Matthew Argersinger doesn't own shares in any of the companies mentioned. Nike is a Motley Fool Stock Advisor recommendation. The Fool owns shares of JPMorgan Chase. 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.


Read/Post Comments (8) | Recommend This Article (23)

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  • Report this Comment On April 04, 2011, at 12:49 PM, Richard233 wrote:

    Valuation is based on perception of FUTURE earnings.

    Facebook may, just may, have achieved enough of grasp of its niche that will be as hard to replace as Ebay is now.

    Is it overpriced? Well, yes and no.

    Goldman Sachs' investment may translate to more than just simple equity in the company, in fact, I'm sure of it.

    What is going to happen is that when they finally do an IPO Goldman Sachs' will have their hands in it. This means they will be getting a percentage of the sales of stocks plus additional business from people/companies that will be buying access to get the stock at the IPO price.

    Think of it like a network that pays a premium for the rights to broadcast a popular show knowing that it will be able to retain a certain percentage of the audience after the end of the show, making the advertising worth that much more pricey for the next show.

    I would not be surprised if Goldman Sachs recovers most of their investment on the day they sell the IPO.

    Figure it will be a high valuation, but more likely in the range of $15-20 Billion after the dust settles.

  • Report this Comment On April 04, 2011, at 4:25 PM, Branchville wrote:

    Just the past repeating itself.

  • Report this Comment On April 04, 2011, at 6:38 PM, 712Mike wrote:

    Face book, face book...I don't have an account. Wfy would I put personal pictures and my life information on the net...gives me creeps. Its worst when people you don't know ask to be friends. My wife has an account...to keep up with our son in Afgan...she get hits everyday with someone wanting to be her friend....I'm her friend.

  • Report this Comment On April 04, 2011, at 7:31 PM, buffalonate wrote:

    Don't forget the cloud stocks. If it is in a buzz industry dumb money will bid it up.

  • Report this Comment On April 05, 2011, at 8:25 AM, midaslefk wrote:

    Obviously it's a bubble, however, don't be so surprised at Goldman and JP investment, they are probably investing to be the preferred underwriters of a future IPO.

  • Report this Comment On April 05, 2011, at 12:40 PM, ETFsRule wrote:

    Still not as overpriced as Amazon

  • Report this Comment On April 07, 2011, at 10:25 AM, TMFMileHigh wrote:

    Hey Matt,

    I think you're oversimplifying here. Facebook is priced at a premium for some very good reasons, all specified here:

    http://www.fool.com/investing/high-growth/2011/03/01/why-ill...

    Also, today's social media valuations differ sharply from the dot-com bubble of the late '90s:

    http://www.fool.com/investing/general/2011/03/28/dont-blame-...

    FWIW and Foolish best,

    Tim (TMFMileHigh and @milehighfool on Twitter)

  • Report this Comment On April 07, 2011, at 7:25 PM, ayalara wrote:

    Just think how many funds are obligated to purchase this worthless garbage for no reason other than its high market cap. And by "funds" I mean folks like you and me that own shares of these funds.

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