This Is Why Secondary Markets Are Dangerous

Just one month after Goldman Sachs (NYSE: GS  ) completed a deal to secure $1 billion in overseas financing for Facebook, it appears that JPMorgan Chase's (NYSE: JPM  ) Digital Growth Fund is in preliminary talks to take up to a 10% stake in Internet messaging site Twitter. Although the deal hasn't been completed, if it were to go through, it would value Twitter at nearly $4.5 billion. That's up more than 20% since the company received a $200 million investment from a group of investors in December.

This could just be the tip of the iceberg, however, and more speculative investments may be on the way. In December, shortly before Goldman Sachs made its own initial investment of $450 million into Facebook, secondary marketplace SharesPost valued Facebook at $56 billion. After shooting briefly to a valuation of more than $80 billion in January, Facebook is currently still valued at $52 billion, according to SharesPost. Despite any concrete figures regarding how much Facebook brings in annually in revenue, consensus estimates for 2010 called for $2 billion. By these figures, it makes the only other publicly traded social-networking site, Quepasa (AMEX: QPSA  ) , look cheap.

The lone analyst following Quepasa expects more than 135% revenue growth in 2011 and 2012. If these robust growth targets were to be hit, Quepasa would be trading at approximately 5 times its annual revenue. Facebook, on the other hand, is probably trading in the ballpark of 25 to 30 times its annual revenue. Now, this isn't a ringing endorsement for Quepasa, which has yet to prove it can turn a profit, but it does help to demonstrate just how far out of whack the valuations of Internet companies have become.

Twitter could just as easily eclipse Facebook in price multiple. At a valuation of $4.5 billion and annual revenue estimates (by some analysts) of less than $100 million, Twitter would be trading at least at 45 times revenue.

What does this all mean?

For one, I think it proves that secondary markets are brutally inefficient and prone to emotional movements that are not as often seen in a publicly traded environment. Secondly, I think it shows how important it is to be able to look at concrete financial statements before investing in a company. Either way, Tulipmania has returned in full swing for social-networking sites, and I think it's just a matter of time before their valuations get deflated down to a realistic level.

What's your take on the valuations currently assigned to Facebook and Twitter? Share your thoughts in the comments section below and consider following the companies mentioned here with My Watchlist.

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