Did Mark Zuckerburg Help Pop the Social-Media Bubble?

"One more victory … and we shall be utterly ruined."
-- Pyrrhus of Epirus

Mark Zuckerburg's ultimate triumph should have come on May 18, when Facebook (Nasdaq: FB  ) went public to more hype, and a higher market cap, than any other tech company in history. Instead, his victory celebration became a wake. The stock's freefall continued, day after day after day, wiping out so much value by month's end that Zuckerburg had fallen off the prestigious Bloomberg global billionaire top 40 list.

Pyrrhus is synonymous with success bought at at too high a price. Still worth nearly $14 billion, Zuckerburg was undeniably a huge winner on May 18, regardless of media narrative to the contrary -- but his successes may eventually come to be viewed in the same Pyrrhic vein by investors and technologists. If so, it'll be a good lesson to learn.

Blowing bubbles
Facebook and the social-media bubble it's blown are in many ways different from earlier technology ventures. Great technological advancements historically succeeded because they improved people's lives, from railroads to mainframes. Facebook succeeds because it monopolizes time and has "network effects," which in this case means that it offers an unvarnished look at the uninteresting thoughts of your exhibitionist friends. Are our lives truly improved by its existence? Does it offer the world any great progress or any notable benefits?

The "Facebook effect," like prior tech bubbles, has had the effect of drawing substantial capital and talent away from other industries. As Facebook took off, the number of Internet-focused startups also markedly increased their numbers and their take of total venture-capital funding.

Sources: PriceWaterhouseCoopers and National Venture Capital Association.

Sources: PriceWaterhouseCoopers and National Venture Capital Association.

These graphs don't necessarily show the full extent of social media's outsized share of private funding, but there are other ways to clarify the picture. Here are a few interesting statistics on the state of social-media funding over the past few years:

  • In 2010, social-media companies received $1.67 billion in venture capital.
  • Social media received 13% of all Internet-focused funding in 2009-2010.
  • Social media received $2.52 billion in venture capital in 2011's first quarter.
  • This was 31% of all venture capital funding distributed during the quarter.
  • In 2011, 61% of all SecondMarket trade value went to consumer Web or social media.
  • The three largest funding rounds of 2011 went to social-media startups, including nearly half a billion dollars to Zynga (Nasdaq: ZNGA  ) , whose CEO divested a significant chunk of his shares within months of the company's IPO.

One venture-capital partner ran with the bulls right off the deep end in late 2010, predicting that social media would grow up to 25 times as large as it was at the time. Based on the numbers we already have, that would mean venture capital might wind up investing almost $42 billion in the space by 2015. That would be as much as the entire Internet sector received from private equity in 2000, at the absolute height of the dot-com bubble. As you can see, there may already be a pullback in progress.

Exercises in futility
This isn't meant to be an indictment of all online-focused companies. Many have worthwhile ambitions. But so much enthusiasm, met with such disappointing results, tends to have a restrictive effect on future funding. It happened after the dot-com bust, when venture capital for online startups dropped from a quarter of a very inflated amount to just under 10% of all funding distributed in early 2004, when Facebook was founded. You can see optimism's return after that point in the two graphs.

However, there are already plenty of signs that the market, both public and private, has turned against the social sector. Few of the major social-media stocks are still in positive territory from their IPO debuts. Some major investors -- most notably venture capitalist Paul Graham of Y Combinator -- are making public their belief that Facebook's flop will hurt funding opportunities for other startups.

Well, good.

The best description of the dot-com bubble I've ever seen comes, interestingly enough, from a satirical article on Cracked.com: "[It] was built on the belief that soon, every single aspect of our lives would be radically reordered around the Internet, based on the scientific principle that a thing that is growing will continue to grow, in every direction, forever." It seems that the same belief has now been applied to social media, as though valuations never come back to earth and a company worth hundreds of times earnings will justify that premium by doubling every year to infinity.

Company

Market Cap / Valuation

Current P/E

Annual Earnings Needed for P/E of 25*

Facebook $66.5 billion 77.6 $2.66 billion
LinkedIn (Nasdaq: LNKD  ) $10.8 billion 716.6 $432 million
Zynga $4.3 billion N/A $172 million
Groupon $7.0 billion N/A $280 million
Demand Media $776 million N/A $31 million
Yelp (Nasdaq: YELP  ) $1.3 billion N/A $52 million
Jive Software $1.2 billion N/A $48 million
Twitter $8 billion N/A $320 million
LivingSocial $2.9 billion N/A $116 million
Foursquare $600 million N/A $24 million
Spotify $4 billion N/A $160 million
Pinterest $1.5 billion N/A $60 million
Tumblr $1 billion N/A $40 million
Apple $545.2 billion 14.2 $21.81 billion
Microsoft $251.2 billion 11.0 $10.05 billion

Sources: Crunchbase, Yahoo! Finance, and news reports.
*Assumes no market-cap change.

Of the major public and private social-media companies, only Facebook and LinkedIn are currently known to be profitable. This small sampling of "social" companies -- Crunchbase contains 7,145 companies tagged with the word "social," though I haven't a clue how many are revenue-generating businesses -- is worth about $107 billion all together, yet only Facebook has any significant earnings. Most of them are essentially advertising companies, as far as their revenue streams are concerned.

LinkedIn is worth more than twice its three major public competitors -- Robert Half, Dice Holdings, and Monster Worldwide (NYSE: MWW  ) -- combined, yet it earned 6% as much in profit as those three did over the past four quarters. Yelp and Jive would need net margins around 50% to earn those 25 P/Es, or would otherwise need to get much better at managing their expenses while growing really quickly in all directions before the market gets bored.

Facebook's IPO was supposed to be the high-water mark of a disappointing string of debuts, leading the charge back to social greatness. Zuckerburg, no matter what happens next, has had his victory. But he's also exposed the flaws of future social-media endeavors as worthy investments. If this flop winds up redirecting investor attention to more meaningful developments, it'll be worthwhile.

After the Pyrrhic War came the glory of Rome. I hope similarly durable greatness awaits us beyond the wreckage of the social bubble. One thing's for sure: Game-changing companies can offer investors fantastic returns and the satisfaction of playing a part in driving real innovation. Fortunately, there are still plenty of transformative technologies left to invest in. Here's one. There are lots more, if you know where to look.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter, @TMFBiggles, for more news and insights. The Motley Fool owns shares of LinkedIn, Apple, Microsoft, and Facebook. Motley Fool newsletter services have recommended buying shares of LinkedIn, Apple, Microsoft, and Robert Half International and creating bull call spread positions in Apple and 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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