Earlier this month, Twitter’s IPO, priced at $26 per share, caused a twitter by rising 73% on debut. Investors tweeted in joy while pundits went for #bubble. While IPOs are usually priced to perform on opening day, such euphoria is usually a sign of excess, for no IPO adviser can miscalculate to such an extent. A whiff of excess is certainly apparent looking at the company’s financials. It made losses in 10 quarters in a row, with the biggest loss in the most recent quarter this year. Although the price-to-sales valuation metric used to justify the IPO price is not as outrageous as the price-per-eyeball accepted at the turn of the century, it is still on the dodgier end of the scale. Returns are ultimately determined not by how much is sold, but by how effectively are sales converted to profits.

However, sceptics are starting to look like the boy who cried wolf. LinkedIn shares closed 109% above the IPO price on debut in May 2011 and were greeted with the same cries of ‘‘tech bubble". Since then, LinkedIn shares have further increased by an astronomical 235% (based on close as of 14 November 2013). Bubble believers’ satisfaction from Facebook’s IPO debacle in May 2012 proved short-lived as its shares took off in July this year and are currently trading at about 29% above the IPO price, giving an annualized return since IPO of around 11%.

While the facts may look damning, investor optimism may not be misplaced. Social media has already transformed our lives. The question is whether these companies can translate their ubiquitousness into hard dollars.

The common theme that runs through the differing business models for Twitter and Facebook is the importance of advertising revenue. In contrast, LinkedIn gets nearly three-quarters of its revenue through functioning as an ‘‘online headhunter" along with charging members. Therefore, investing in Twitter or Facebook requires a view on how much advertising spend they can capture in future.

The Internet (including mobile) is poised to overtake television as the main advertising medium by spends just as TV overtook print. Social media is the third wave in the mass communication revolution that started with Gutenberg’s printing press. Its unassailable advantage is that it offers users an active experience compared with TV and print (think social networking, online gaming, etc.). The dominant media companies of the last century with their stable of TV channels are being pushed aside by Internet giants such as Google and Facebook with their portfolio of websites (think YouTube, Instagram, etc.) aimed at ‘‘viewers". In fact, Google is already the biggest media company in the world.

As the already-large social media user base continues to grow and companies mine data of online behaviour to build increasingly detailed consumer profiles, advertising dollars are going to migrate to this medium. Indeed, this is already happening, with online and mobile advertising spends capturing an additional 15% share over the last decade to account for 18% of total spends currently. So far, most of the gains have been at the expense of print, but as TV viewers migrate online, advertising dollars will follow.

Global advertising spend is estimated at around $500 billion and is poised to grow 5-6% over the next couple of years. Online and mobile advertising is $90 billion of this, with Facebook, Twitter and LinkedIn accounting for nearly $7 billion. For current valuations to be justified, the online and mobile share of ad-spends needs to grow at a far more rapid pace than before. Moreover, within this, the share of Facebook and Twitter needs to grow. Graph 2 shows that earnings growth of 40-50% per annum is possible if the share of online advertising doubles along with the share of the three companies within it.

Even with these generous assumptions, earnings growth of 40-50% doesn’t quite reach the levels expected by the market given the current valuations. It can be argued that costs will come down as these companies mature and the investment requirement reduces. However, achieving expectations on earnings growth will require Twitter and Facebook to diversify their revenue streams to reduce dependence on ads. LinkedIn with its diversified revenue stream is in a slightly different position. It need not meet earnings expectations as long as it can prove its ability to disintermediate the traditional recruiting process by directly connecting candidates to companies. The market usually buys such stories if there is enough substance behind it. It has been chasing the pot of gold at the end of the disintermediation rainbow with Amazon (P/E ratio of ~1,300) and may do the same with LinkedIn.

In conclusion, current valuations do appear stretched and require everything to pan out perfectly. However, they are not as incredible as sceptics paint them to be given the transformational nature of social media. As an investor, the greater risk you face at this juncture is probably macroeconomic. Markets in general have benefited from easy-money policies across the world. The end of such policies is unlikely to be pretty. As many a hedge fund titan found out in 2008, investing based on individual company analysis is well and good, but ignoring the larger forces at play is foolhardy. Invest in social media stocks if you feel convinced by their potential, but do hedge against broad-based market declines.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.

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