Social Networking Bubble Inflating

Technology companies like LinkedIn, Pandora, Groupon and Facebook are being valued at mind-boggling revenue multiples. In the face of relatively meager earnings, the fast-growing niche of social networking looks severely overvalued, bringing back memories of the last decade's dot com bubble.

Technology companies like LinkedIn, Pandora, Groupon and Facebook are being valued at mind-boggling revenue multiples. In the face of relatively meager earnings, the fast-growing niche of social networking looks severely overvalued, bringing back memories of the last decade's dot com bubble.

Over the past couple of weeks one must increasingly have been under the impression that technology history may be about to repeat itself. Again, technology companies, many of which are still in their start-up stages, are being valued at mind-boggling revenue multiples that the respective companies and venture capitalists are trying to justify by pointing to web statistics such as page views, unique visitors, registered users or even entirely new metrics they invented themselves ("income before expenses", as they are often called). Groupon, for instance, introduced a metric called "adjusted consolidated segment operating income" (short: Acsoi). Supposedly, Acsoi is the firm's operating profit minus its marketing and acquisition expenses. Under US accounting standards, Groupon shows a loss of more than $400m, using Acsoi this magically turns into a $61m profit.

What do these income-before-expense-metrics tell about the companies' financial situations and outlooks? This is a rhetorical question, of course, with the answer becoming evident when looking at technology stocks in the early 2000s. What they are supposed to cover up, is that most of the new web start-ups are severely overvalued not only in terms of the 2010 revenue multiples, but also based on multiples derived from current 2011 revenue outlooks. Is it the year 2000 all over again?

Almost. This time it is not the entire technology sector that is overvalued, but it is the relatively narrow niche of social networking firms. The shares of professional networking site LinkedIn, for example, jumped more than 150% to $122.7 on the day of its IPO on May 19, 2011, only to fall back to $67.92 as of this writing. LinkedIn reported a profit of $3.4m last year, mostly from advertising and membership fees. This is a tiny profit, considering the firm's current market capitalization of $6.4bn. Pandora, an online radio site which is valued at $4bn despite revenues of little over $100m last year, benefited from LinkedIn's IPO too. But under its current licensing terms, the more songs users listen to, the more Pandora ends up paying in royalty fees. This deal alone lacks entrepreneurial brains, in my opinion.

Granted, social networking firms are growing fast. But as long as web 2.0 companies are not able to translate their extreme popularity and growth into sustainable profits, I prefer to remain sceptic. Advertising alone cannot be the answer to this problem. With the increased use of ad blockers and general "ad blindness" by today's internet users, relying almost exclusively on paid ads will turn out to be a dangerous business model. Even Google has realized this by now and is beginning to branch out into new markets such as cloud computing, operating systems and telecommunications.

Unfortunately, it is not just the absence of robust business models that should caution potential investors. The aforementioned creativity in terms of financial accounting and reporting is just as big a problem. As an investor, I choose not to trust a company that is desperately trying to cover up losses and turn them into profits using non-standard accounting rules.

Recommended reading:
- Accidental Billionaires: Facebook (Paperback) | (Kindle Edition)
- The Google Story (Paperback)(Kindle eBook)
- Wikinomics (Paperback) | (Kindle eBook)