Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.
Even if you had several billion dollars, would you pay $1 billion for a two-year-old firm with no revenue and slim odds of ever producing anything of substance? Probably not. Would you invest in a company that bought said firm? If not, you probably wouldn't have wanted to invest in Facebook when it finally went public.
In April, Facebook CEO Mark Zuckerberg showed just how precarious his company’s position is at the top of the social media heap when he paid $1 billion (all currency in U.S. dollars) for Instagram, a photo-sharing app that has attracted more than 40 million users, despite having just a dozen employees. Facebook is, in large part, a photo-sharing service itself, and he was obviously paranoid about the competitive threat Instagram posed.
Brokerage firm analysts—who are likely hoping their employers will get a piece of Facebook’s investment banking fees—applauded the deal. Many of them say that Facebook’s stock market value could be as high as $96 billion, meaning it can easily afford Instagram.
In fact, the purchase underlines just what a difficult business social media can be. A lot of investors concentrate on the ability of these firms—Facebook, Groupon, LinkedIn, Yelp and so on—to attract eyeballs and (they hope) advertising dollars. The trouble is that there are very few barriers to entry in social media. Facebook basically admitted this by paying $1 billion to neutralize a competitive threat that was barely off the launching pad.
So why are social media companies accorded such rich valuations? LinkedIn, which went public in May, 2011, has a stock market value of $11.3 billion, or 912 times its earnings. Groupon has a market cap of $6.6 billion, and it doesn’t even make money. Online games leader Zynga is valued at $6.3 billion, and it doesn’t make money either.
As for Facebook, at the middle of the range of possible share prices for its IPO that it announced in May, it would be worth about 24 times its sales of $4 billion for the 12 months up to March 31. That’s twice Google’s valuation when it went public in 2004. Google now has a market cap of about $200 billion. But the company earns piles of money, so its share price is a modest 19 times its earnings per share, and just five times its sales per share.
Investors in social media are obviously hoping to score Google-like returns. But they can’t all be right. Social media is, by and large, an advertising business, and total ad spending in all media is basically flat.
The aggregate value of all media stocks is now probably more than half a trillion dollars, which is undoubtedly much more than all media companies before the age of Google and Facebook. That means there will be some spectacular investment losses in social media. There have been casualties already, such as Groupon, which has lost more than half its value since its IPO last fall.
Even Facebook isn’t immune. The company’s first-quarter profit declined despite higher revenues, because it had to spend a lot more money attracting eyeballs than it can recoup from advertisers. It’s also competing with the mighty Google for those advertisers’ dollars.
It’s easy to say the social media phenomenon is just the tech bubble all over again. It’s not the same. It’s a more sophisticated, subtler bubble—but it’s a bubble nonetheless.
THIS MONTH'S TIP SHEET
GROWTH Brigus Gold Corp. Price-to-sales ratio (trailing 12 months): 2.3 Sometimes it’s hard to get the yellow stuff out of the ground. After a transformative merger in 2010, Brigus hit some bone-jarring bumps at its Black Fox Mine, near Timmins, Ontario. CEO Wade Dawe has taken corrective action, but the share price, which swooned like a southern belle on a hot day, has been slow to take notice. With production back on track, investors should benefit from rising output and falling costs per ounce.
VALUE AvenEx Energy Corp. Dividend yield at recent share prices: 10.7% AvenEx’s directors look like their idea of a rollicking time is to have a second cup of Earl Grey. So when they cut the company’s monthly dividend in April because of low natural gas prices, they were trying to be prudent. AvenEx’s oil and gas production and marketing businesses are steady, but gas is near rock-bottom prices. With the dividend payout ratio now near a manageable 60% of the company’s funds from operations, that lower dividend looks safe, and the yield is still juicy.