Thursday's Top Upgrades (and Downgrades)

This series , brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. On Thursday, we focus on three picks by British megabanker Barclays, which has announced a series of picks (and pans) in the social networking sector, including two buy recommendations for Facebook (META -1.87%) and Twitter (TWTR) -- but not for LinkedIn (LNKD.DL).

Let's start with the standard-bearer for the category, and work down from there.

Facebook
Priced at $67 and change today, Barclays sees Facebook -- the inarguable leader of the social networking movement -- as likely to rise to $78 over the course of the coming year, and likely to outperform the rest of the stock market in the process. If Barclays is right about that, then investors today can look forward to about a 15% profit on the stock. But what if they're wrong?

Priced at nearly 88 times earnings today, Facebook's valuation looks like quite a stretch -- even if analysts are right about their consensus estimate that the stock will grow earnings at nearly 35% annually over the next five years. Fortunately for investors (and for Barclays), things aren't quite as bad as they look.

According to S&P Capital IQ data, Facebook actually generated close to $3.4 billion in real free cash flow over the past year, despite reporting GAAP "earnings" of only $1.9 billion. What this means is that, if you give Facebook credit for its $12.2 billion in net cash, the stock really only sells for an enterprise value-to-free cash flow ratio of 47.5.

That still seems a high price to pay for 35% growth, but it also means that Facebook is really only about half as expensive as the stock's P/E ratio makes it look. Barclays adds that, in addition to its valuation arguments, it sees Facebook as benefiting most from trends such as "innovation in search and email," monetization of international users, and the "network effect" (whereby sites tend to snowball, becoming exponentially more valuable the more users they accumulate). Long story short: They like Facebook, and urge investors to buy it now.

Twitter
Facebook-lite, or Twitter, is Barclays' second endorsement of the day -- albeit the analyst's $46 price target suggests there's only about 12% upside in this stock from today's prices. Unfortunately for investors, there's also considerably more risk here to the downside.

Unprofitable where Facebook is making money, and free cash flow-negative where Facebook is churning out greenbacks, Twitter burned through $72 million in cash losses over the past 12 months. On the plus side, operating cash flow has turned positive at the company, and so there's hope that Twitter will eventually begin breaking even on a cash basis. On the minus side, capital spending is growing, too -- raising the risk that the FCF-breakeven point could still be some years away.

Most analysts who follow the stock agree that Twitter will eventually find its way to GAAP profitability, at least, by about 2018. What investors have to decide, though, is whether they're willing to wait around for another four-and-a-half years to find out if they can really get a return on their investment in Twitter -- or just buy Facebook instead, which is profitable today. For most investors, I suspect that will be an easy choice to make.

LinkedIn
Last but not least, we come to LinkedIn -- the "professional" Facebook -- and this time the news is not so good for shareholders.

Endorsing Facebook and Twitter as "outperforms," Barclays declined to name LinkedIn an outperformer as well, saying only that it expects to see the stock perform about as well as the rest of the stock market, and rating it "equalweight." Why?

Unprofitable like Twitter, but free cash flow-positive ($139 million generated over the past year), LinkedIn has no P/E to value it on. It does have a price-to-free cash flow ratio, however: 145. It has an enterprise value-to-FCF ratio, too: 128.

Problem is, both of these numbers look pretty shocking when placed in comparison to Facebook's valuation. Given that the stocks have nearly identical projected growth rates (35% for Facebook, 34% for LinkedIn), there's really no reason for an investor to willingly pay the higher price at LinkedIn for growth nearly identical to (and actually a bit slower than) what Facebook offers.

Long story short, I'm still not quite clear on why Barclays thinks Twitter is a better buy than LinkedIn. But I do get why Barclays' analysts prefer Facebook over LinkedIn -- and what's more, I agree with them.