Plenty of Reasons to Be Wary of the Facebook Hype

One year ago, daily deals sites were all the rage. Shares of travel-deal specialist Travelzoo (Nasdaq: TZOO  ) were worth $74, three times what they are now; Open Table, which deals in restaurant reservations and at the time offered daily deals, sold for nearly $100 before crashing to the mid-$30s. Google and Amazon.com were getting into the deals game, and investors eagerly awaited Groupon's (Nasdaq: GRPN  ) IPO.

The market loves to overvalue the next big thing, especially when it comes to the Internet. During the height of the tech bubble, the P/E of the S&P 500 was over 40, while its historical average is near 12. As the raft of Web 2.0 IPOs have come and gone, all except LinkedIn (NYSE: LNKD  ) sit below their first-day close, while some, including Groupon and Pandora, have dropped by more than 50%. With Facebook set to go public next week, this seems like an appropriate time to look back at past follies in the tech-valuation game.

Facebook does not equal Google
There are plenty of reasons to balk at Facebook's nearly $100 billion valuation.

When Google IPOed in 2004, it was worth about a third of Facebook's current valuation, despite having similar revenue. Since then, Google has increased sales more than tenfold, maintained profit margins over 20%, and taken its influence from search to nearly every corner of the Internet, including Chrome, Gmail, and its acquisition of YouTube. The search king has also grabbed a foothold in the mobile market with its Android platform, and with innovations like Google Wallet and Google Glasses, the company clearly has plans for developing new revenue streams in the future.

While Facebook's recent purchase of Instagram could be seen as branching out to new products, the company is primarily focused on its core offering as a social network. Facebook has plenty of ideas about how to integrate itself into every aspect of your online life, such as payments, sponsored ads, and a potential Facebook phone, but the company risks pushing users away by inundating them with unwanted ads and requests.

Facebook also appears to be maturing in its more established markets. The website's membership in North America actually decreased slightly in the past year, and nearly all of its membership growth is now coming from developing countries, meaning it won't be able to command the same level of ad revenue for its new users.

The main difference between Google and Facebook, though, seems to be that for users, the search engine is a tool, while the social network is just entertainment. Google invents a new way of data sharing with Googledocs; Facebook comes up with the "Like" button, considered one of its most important innovations. This value distinction can be seen in users who have left Facebook, complaining that it's a time-waster or feeling creepy over knowing so much about strangers. That issue would seem to indicate that Facebook, in a way that Google does not, risks driving users away with its invasive nature, an aspect that is likely to become more pervasive.

There are bridges over that moat
With 900 million members, Facebook is clearly the preeminent social network in the world, but others have crept up and are now competing for social-networking eyeballs. LinkedIn has carved out a niche as a professional network and now has more than 150 million members. Twitter has become the go-to source for news as well as the best social-network connection to celebrities, all forms of media, and anything immediate. The site reached 140 million members in March and is projected to hit 250 million by the end of the year. Now, the newest belle of the ball may be Pinterest, a social network with close to 20 million monthly users who can pin images, videos, and other items that they want to share on their board.

While none of these companies alone is likely to topple Facebook, they all show that there is room for competition and that Facebook's continued dominance of social media is not guaranteed. The company certainly has an advantage through network effects and switching costs, but it could be vulnerable to having users leave if it leans on advertising too hard. After all, My Space had the same built-in network effects and switching costs.

The mobile switch
The mobile revolution is the biggest change to hit the tech world since the creation of the Internet, and the shift in eyeballs from computer screens to smartphones is upsetting the business model of companies such as Facebook. The social-networking giant makes much of its revenue from the target ads on the right side of the screen that users see when they login on their computers, but since mobile screens are so much smaller, this advertising tactic will not cross over. Monetizing its mobile site has been a struggle so far.

The company has revealed that user growth has outpaced ad revenue recently and has said that the trend "may negatively affect" financial results. The company's first-quarter revenue of $1.06 billion actually dropped 6% from Q4 2011, though seasonality appears to be a factor, considering that it grew 45% versus the prior-year quarter. Year-over-year profits, however, declined 12% to $205 million for the quarter, and its CPM rate has been flat, which the company blames on growth in emerging markets where prices are lower.

The mobile transition and questions surrounding the sustainability of Facebook's growth underscore the fact that despite its massive user base and penetration across the Web, the company still faces with the classic monetization problem that's plagued other social-networking websites such as Twitter or YouTube in its early days.

Foolish takeaway
Valuing a company like Facebook is notoriously difficult, but its $96 billion IPO would be a record for an American company. And with price-to-sales ratio of 25, it's in a class of its own. By contrast, Microsoft (Nasdaq: MSFT  ) had a P/S ratio of just 4 when it went public, and most tech companies trade in the range of 4 to 10. Facebook may not be your run-of-the-mill tech stock, but there are plenty of reasons to be skeptical of its growth. With its limited utility, impending user saturation, and the constant advances in technology changing the competitive landscape, Facebook has plenty to prove as it makes its grand entrance. I'll be waiting on the sidelines until shown otherwise.

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Fool contributor Jeremy Bowman owns shares of Google. The Motley Fool owns shares of OpenTable, Google, LinkedIn, Amazon.com, and Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft, LinkedIn, Amazon.com, OpenTable, Travelzoo, and Google and creating a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On May 14, 2012, at 12:34 PM, rollhard wrote:

    At least ppl will have a forum to talk about how mark and #fb made their money disappear. The only reason I can see for #fb to go public is to find ppl looking for the next big thing and separate them from their savings and investment money.

  • Report this Comment On May 14, 2012, at 2:53 PM, rhcole wrote:

    I think FB may be overvalued by as much as $60 Billion, and I will gladly be buying LinkedN or others before I pour a lot of money into FB stock during its IPO.I am afraid that its stock may head the same way Groupons did when it went public and tanked, I think FB may be the next greatest thing thats already been the greatest thing..

  • Report this Comment On May 14, 2012, at 3:02 PM, Extremecrabber wrote:

    My biggest reason and the main reason most of the Dotcoms are gone now from 1997: Facebook has all this money supposedly, and they can't seem to hire a decent programmer!!!! Their smartphone and tablet apps are TERRIBLE. Full of bugs. Read the reviews on the Apple store under the Facebook app. That's enough to make me steer clear. Something as fundamental as that - enough for me.

  • Report this Comment On May 14, 2012, at 3:42 PM, Clint35 wrote:

    I can't wait for their IPO so I can give it a big red thumb on CAPS. I think it'll be my best underperform pick ever.

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