Betting on Social Networking

by: NYC Trader

It appears that Goldman Sachs (NYSE:GS) has found another way to generate revenue. This time, they won’t be using houses or derivatives to make their cash. They will be using Facebook.

As the Social Networking chase continues in the secondary markets, Goldman announced an investment of $500 million into Facebook. That valued Facebook at a cool $50 billion and as a comparable, helps drive up values of other sites like Twitter and LinkedIn. LinkedIn, which got a $20 million boost for a 1% stake back in July from hedge fund Tiger Global Management, has been looking more attractive to investors as the Facebook valuation continues to climb. The July partial stake in LinkedIn valued the company at $2.2 billion ($21.50/share). Currently, investors on SecondMarket.com have an Ask price on the LinkedIn stock at $25/share, or $2.625 billion, which would create a 16% increase in a 6 month period. As LinkedIn continues to introduce new premium channels, my forward estimated price target for LinkedIn is $27.50, which is a 28% increase over its current price. The complete model is below:

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I’ve argued, however, that using these valuations is extremely risky. The social networking financial models, although appearing relatively simple, are betting heavily on growth. Facebook, at the latest valuation of $50 billion, is valued at 25x its 2010 revenue and almost 105x earnings (Apple (NASDAQ:AAPL) is 22x earnings). To get to the same earnings multiple as Apple, Facebook would have to quadruple its revenues and increase profits by 500%. The current model values LinkedIn at 11x current revenue and 56x earnings. Such betting on growth would most likely require Facebook and LinkedIn to introduce additional and unproven layers of paid content to its users.

Some of the risks, therefore, are as follows:

  • As second markets are not regulated, private companies aren’t obligated to report their financial health. Most investors outside of the early VCs are speculating on the companies’ financial growth.
  • There is absolutely no way to verify whether Facebook has 550 million users or LinkedIn has 80 million users. Many individuals are known to open multiple accounts, while the social networking sites count these users as “unique.” The number of users have been known to be used in valuations to project ad revenue.
  • As the companies will be required to introduce additional layers of premium content to sustain projected growth, it is still questionable whether these new business models will work.
  • As investors continue to use blind pools to raise capital, will the Securities and Exchange Commission change the regulation laws towards private stocks in the secondary markets?
  • Competition will likely increase.

One thing is for sure. Investors, VCs and several Investment Banks are continuing to pile in loads of cash into the Social Networking arena in hopes of capitalizing heavily on the IPOs. I am entirely convinced, however, that growth will undoubtedly slow and the later investors will pay the price.

Disclosure: I am long AAPL.