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Is Social Networking all Hype?

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Two of the hottest stocks in the market today are social networking leaders, Facebook (NASDAQ: FB  ) and LinkedIn (NYSE: LNKD  ) . Facebook currently trades at 70 times the average analyst estimate for this year's earnings, while LinkedIn comes in at a mesmerizing 162 times expected earnings. Is there any way to justify these seemingly outrageous valuations? Or, is the social networking bubble about to burst?

Looking to a giant
There's no mature social networking company to compare with Facebook and LinkedIn, so the closest comparison is Google (NASDAQ: GOOGL  ) . Google, dominant in search and online advertising, has grown revenue at an annualized rate of 48% since 2003, achieving a net income margin of about 21% in 2012. Are the social networking companies reasonably priced if they take the same growth path as Google?

Regarding Facebook, trailing-12-month revenue stands at $6.1 billion, roughly equal to Google's revenue in 2005. Since 2005, Google has grown revenue at an annualized rate of 35%, so let's assume that Facebook does the same. This assumption would lead to revenue of $50 billion in 2020. With the same profit margin that Google has now, Facebook would then be earning roughly $10.5 billion.

Today, Facebook is valued at about $125 billion, putting the stock at 12 times the hypothetical 2020 earnings. Google is currently valued at about $300 billion, and if Facebook reaches the same valuation in 2020, investors buying today would achieve an annualized return over 13%.

LinkedIn's trailing-12-month revenue is roughly equal to Google's revenue in 2003. Assuming 48% annual growth and a 21% profit margin by 2022, LinkedIn will be earning $9 billion on $42.5 billion in revenue. Applying Google's current P/E ratio to LinkedIn yields a market capitalization of $250 billion for LinkedIn in 2022.

LinkedIn is valued at $29 billion today, and investors will achieve an annualized return of 27% if the stock is bought today and the above scenario plays out. 

Fantasy or reality?
Are the above scenarios plausible? Facebook already has over 1 billion users, putting the current revenue per user at about $6. Facebook can grow both the number of users and the revenue per user. As long as it remains the premier social network, there's no reason both of these values can't get much bigger. If Facebook doubles the number of users by 2020, revenue per user, under the above scenario, would then come out to $25, quadrupling today's figure.

This would require Facebook to greatly expand its advertising influence, something that it's working hard at today. Facebook is reportedly testing video ads, and the company is taking steps to make its ads less annoying and spammy. This is critical for preventing users from fleeing, as annoying ads can act as a deterrent. It's certainly possible that Facebook's growth follows Google's growth, but it's not a given.

Facebook is competing directly with Google, trying to shift spending from search and display ads dominated by Google to Facebook ads. Google derives most of its revenue from advertising, and it's hard to imagine ads on a social network will be more effective than Google's offerings. Google isn't asleep at the wheel, either. The company is always trying to make its solutions better, including the recent launch of the Web Designer tool, which aims to make designing display ads easier.

Even the best case scenario for Facebook only leads to a 13% annualized return. There's no margin of safety with Facebook at current prices; an argument could be made at $20 per share, but not today. Because of this, Facebook seems overpriced.

LinkedIn follows a different model. The company focuses on professionals, monetizing its users by helping recruiters find qualified applicants. The company also sells advertising and premium memberships, but its recruitment services are the key to its success. The business model is superior to that of Facebook since it doesn't rely solely on selling ads.

But, there's a problem. It's unclear how big LinkedIn can really get, since it isn't a service aimed at everyone, like Facebook. LinkedIn is attempting to combat this by launching University Pages, an offshoot that helps high school students explore colleges. This seems like a good idea, but each time the company broadens its user base it becomes more like Facebook, and the last thing LinkedIn needs is to be viewed as a Facebook clone.

In terms of valuation, the potential exists for exceptional returns. But, it's unlikely that LinkedIn can match Google's growth due to its limited focus, and while it could end up a very strong niche social network, it will never be a $300 billion company. The nosebleed valuation is likely unjustified, and I would stay away at these exorbitant prices.

The bottom line
The social networking industry seems overpriced, with optimism overpowering realism. Facebook has the potential to become a huge company, but the price is so inflated that an investor's return wouldn't be worth the risk. LinkedIn's size is likely capped, and it's difficult to tell how big it can get without entirely changing the dynamics of the site. I would avoid both, and eventually the stock prices will come back to reality.

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