The social-networking arena is red-hot. Rupert Murdoch looks like a potential genius for purchasing for just $580 million in July 2005 -- especially when you consider that Facebook, a much smaller site, turned down an offer for $750 million and is reportedly looking for $2 billion.

Ah, the college years . is a popular website where college and high school students gather, exchange information, and generally hang out and have a good time. Harvard student Mark Zuckerberg and some college friends started it up two years ago, and within a few weeks it consumed the Harvard campus. It's available only to college students who have an educational email address -- that is, an address ending in ".edu." By forcing this requirement on users, the site collects only highly valued users in the 18-22 age range, tapping into a key demographic for advertisers. It quickly grew to become one of the most popular sites on the Internet; Facebook ranked seventh, with 5.5 billion page views, in February 2006, ahead of Internet luminaries such as (NASDAQ:AMZN).

For advertisers, the site has developed into a new outlet to reach young adults and teenagers, who spend up to an hour a day posting messages, blog entries, and photos, and adding new friends to their lists. Advertising comes from locally focused text ads (i.e., targeting one specific college), national banner ads, or sponsored advertising. Currently, the website supports 2,100 colleges and 22,000 high schools.

The loyalty and dedication of Facebook's users is staggering. The site has about 85% penetration into the colleges it supports, and it boasts more than 6 million registered users. Of that sizable base, 60% log in daily, 85% once a week, and 93% once a month.

The real value that Facebook offers to advertisers is the ability to see relationships and shared interests between users and their friends. Effectively, a company could look at what your friends like, then recommend those same products to you, knowing that you might be predisposed to purchase them. That's worth a considerable amount to advertisers.

So, what VC firm hit the latest grand slam?
The company raised about $12.2 million from Accel Partners in May 2005, with a rumored valuation at the time of about $100 million. In addition, in April 2006, the company completed another round of funding with Greylock Ventures at a rumored valuation of $525 million.

And now it's trying to sell for $2 billion!?
Yep. So whom do we blame for this near insanity? Try Rupert Murdoch and a little site called A casual visitor checking out might wonder why Murdoch, of News Corp. (NYSE:NWS) fame, sank $580 million of shareholders' money into such an unusual site, a vast collection of blogs from teenagers and twentysomethings looking to hang out. Here's why: The social-networking site is hugely popular, with about 23.5 billion page views in February 2006, second only to Yahoo's 30 billion, according to comScore data. It also has about 37 million unique users. Despite the incredible popularity of the site, though, it is estimated to have brought in only about $30 million to $40 million in revenue in 2005, and it's expected to double that amount in 2006 to the range of $80 million to $100 million.

Murdoch effectively paid a price-to-sales ratio of 14.5 to 16.5 for -- hefty, to be sure. But because Facebook is a much smaller site, and if page views and registered users are in any way indicative, we might expect its revenue to fall in the $5 million-to-$10 million range. That means a buyout at a price of $2 billion would place the company at an eye-popping price-to-sales of 200.

Now, to be fair, valuation in these rather nascent spaces is not necessarily based on straight sales. A hefty doze of buzz and continued high growth are often built into the acquisition price. After all, MySpace is now growing by approximately 250,000 users daily, up from just 100,000 users daily last summer. Since there is little actual financial data available, we cannot ascertain advertising profitability or margins, but one thing remains -- these prices are rich by my standards.

Who is going to be crazy enough to pay that price? (And, boy, do I have an idea to pitch to them!)
A lot of me-too players, led by Viacom (NYSE:VIA) and Sumner Redstone, according to industry analysts. Unfortunately, Facebook, much like the Skype acquisition, is being valued as if it were already highly successful and its risks minimal, which is hardly the case. While old-media companies like New York Times (NYSE:NYT), Washington Post (NYSE:WPO), and the like have all made fairly expensive new-media acquisitions, a $2 billion deal has the potential to blow them all out of the water.

I think it'd be far easier, and probably a better return on investment, to spend the $2 billion on developing online social networking properties that would allow current offline media to transition users from traditional media to the Web, despite the premium associated with an established name and property. Frankly, if this deal goes through at this price, I'd say it should be a clear indication of the acquirer's desperation to get into the social-networking game.

The 2006 version of Woodstock?
It's clear that social-networking sites are here to stay in one form or another, and there is vast potential for marketers to be able to target very specific demographics. What's more, marketers have a Holy Grail of sorts on their hands -- they can use the data publicly available in a profile and from links to friends to target products on an almost one-to-one relationship. But more innovation needs to happen before advertisers can be encouraged to pay higher ad rates and be more confident in the new channel. For example, MySpace recently launched a new site for short films and video clips, building on the site's success as a launch platform for new and unsigned bands.

MySpace and Facebook do face risks as they go forward. User backlash and eventual mass exodus in response to becoming more "mainstream" is a genuine risk. To be sure, I'd wager that these companies need to sustain hearty growth if they're to maintain their current valuations. The sites need to improve communication patterns and tie themselves into the continual networking between peer groups. This is key to long-term value creation for the social-networking sites, and it must happen in order for their acquirers to obtain a respectable return on their investment.

After all, new competitors will surely enter the market, creating further pressure on ad rates. Maintaining and strengthening ties between users is crucial to retaining them and improving the value proposition to advertisers. It may seem a simple task, but when sites are adding 7.5 million new users in a month, as is, it becomes amazingly difficult. Buyer beware.

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Stephen Ellis welcomes your feedback at He does not have a MySpace or Facebook account, nor does he hold shares in any of the companies mentioned in this story. The Motley Fool has an ironclad disclosure policy.