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Should You Join the Social Media Craze?

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Investors are seemingly tripping over each other to bid up shares of major social media stocks. Valuations have skyrocketed, along with share prices of Facebook (NASDAQ: FB  ) , LinkedIn (NYSE: LNKD  ) , and Groupon (NASDAQ: GRPN  ) , as there appears to be no price for these stocks that investors are unwilling to pay.

It's clear that these companies operate highly popular businesses and are securing millions of new users every quarter. These are truly revolutionary services, but prudent investors, or those who take valuation into account when evaluating stocks, must be scratching their heads. For all the hype, these companies remain unable to generate profits to a significant or consistent degree. Should investors really be so willing to throw valuation out the window? Or, are these stocks poised to soon ratchet up profit growth and justify their lofty valuations?

Valuations run amok
While I don't dispute the idea that Facebook, LinkedIn, and Groupon are revolutionary technologies that have forever disrupted and changed the world, I can't help but be concerned about the levels at which these stocks are trading.

Some might say that with social media stocks, valuation doesn't matter. To that, I would ask: Doesn't it always matter? Investing in companies that have soaring stock prices, all the while being unable to consistently be profitable, seems to be asking for trouble. It's certainly true that Facebook, LinkedIn, and Groupon are registering impressive growth in certain metrics, such as revenue and active users. However, what investors should care most about -- profits -- is still lacking.

For instance, Facebook earned exactly one penny per share in profits in 2012. To be fair, Facebook grew revenue by 37%, which is impressive. At the same time, Facebook's expenses more than doubled during 2012. On a forward-looking basis, Facebook exchanges hands for 52 times future earnings estimates.

Meanwhile, LinkedIn amassed a grand total of $0.19 per share in diluted earnings last year, despite registering 86% revenue growth. The company expects at least $1.45 billion in revenue this year, which would, again, represent impressive year-over-year growth. Unfortunately, LinkedIn is not providing earnings-per-share expectations, making matters even more complicated for investors to sort through. Analyst expectations place a 115 forward P/E multiple on LinkedIn.

For its part, not only does Groupon trade for 43 times forward earnings, but it's dealing with a unique set of issues that have caused even more uncertainty. Most prominent is its ongoing trouble with the Security and Exchange Commission, which first surfaced in May of this year. At that time, the SEC urged Groupon to more clearly explain certain metrics it was using in its earnings reports. This wasn't the first time Groupon received a scolding for its questionable accounting methods. Last year, the company had to restate results after it revealed a weakness in its financial reporting measures. Things became even more precarious when former Chief Executive Officer, Andrew Mason, was abruptly fired in February.

Ignore valuation analysis at your own risk
Social media stock prices keep rising, making it extremely tempting to jump in and buy, even at these levels. It's understandable that investors would fear missing out on what are revolutionary technologies that could mint millionaires out of its investors. At the same time, though, investing decisions based on emotion are often ill-advised.

While I wouldn't go so far as to call social media stocks the next tech bubble, there are certainly haunting similarities between how these stocks trade and what happened during the last tech bubble. In 2000, Internet companies sprang up, seemingly out of nowhere, and saw their stock prices soar, despite having questionable business models with little underlying profits. At the time, analysts routinely advised investors to ignore the bottom line, and instead focus on top-line items to justify valuations. It was proven then that climbing up the income statement to justify a stock's valuation is often a foolish decision. Only time will tell if social media investors will be burned in the exact same fashion.

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Related Tickers

9/28/2016 4:00 PM
FB $129.23 Up +0.54 +0.42%
Facebook CAPS Rating: ***
GRPN $5.26 Down -0.07 -1.31%
Groupon CAPS Rating: *
LNKD $192.29 Up +0.09 +0.05%
LinkedIn CAPS Rating: ***