Do Yourself A Favor: Stay Away From Social Media Stocks

Includes: GRPN, LNKD, ZNGA
by: Shmulik Karpf

Facebook filed for an initial public offering on February 1st that could value the social network between $75 billion and $100 billion, putting the company on track for one of the most-anticipated U.S. stock-market debuts of all time.

Basking in the light of Facebook were three social-media peers that came public last year: LinkedIn (NYSE:LNKD), Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA). All of them enjoyed extraordinary increases in share price over this past week as a result of the hype that evolved around the Facebook S-1 -- LNKD gained 9%, GRPN jumped by 22% and ZNGA skyrocketed by 26%.

Is This For Real?
When we watch how annual returns in the stock market are made in just under a week, our first reaction is to join the crowd. It borders on impossible for any investor watching these mouth-watering returns to stay on the sidelines. The more a stock goes up, the more it seems likely to keep going up. But before we jump on the wagon of social media, let's take a hard look at the current valuation metrics of those companies:

LNKD ZNGA GRPN Facebook (Estimated)
P/E (ttm) 1,000 180 N/A 100
Price/ Book 18 8.5 11 Unknown
Price/ Sales 17 10.5 11 20
PEG Ratio 3.1 2.9 N/A Unknown
Dividends Non Non Non Non

It seems that based on any metric we might choose, all of those companies are more expensive than expensive. In fact, even if their respective prices had been cut in half, I still would not have touched them with a stick. Just in order to simplify things:
  1. For LNKD to become fairly priced (P/E of 30, at the most), the company must increase its annual revenues by 50% for the next 17 consecutive years, or by 20% for 38 years in a row.
  2. For ZNGA to become fairly priced in terms of growth (EPG=1, at the most), the company needs to TRIPLE its current annual earnings growth, which currently stands at 114%. Put differently, ZNGA needs to show a sensational (and obviously unsustainable) earnings growth of 342% per annum.
  3. GRPN has yet to show a profit so it has no P/E ascribed to it, which only makes matters worse. But based on its Price/Book, in order to become fairly priced (P/B=2, at the most), GRPN's stock price must decrease by more than 75%.

It is hard to believe the numbers. But numbers do not lie. Only people do.

Reality Vs. Dreamland
Can any of these companies maintain the growth rates previously mentioned? History provides us with a very straightforward answer to that question.

Carol J. Loomis, in her article, "The 15% delusion", clearly states that maintaining such high growth for years is on the verge of impossible. In particular, when checking per-share growth for the largest 150 companies over a two-decade period, it appears that the number of companies who were successful in performing that task was very, very small.

"Though history shows how difficult it is for large companies to hit a 15% target in earnings over any extended period, there remains no scarcity of executives willing to assume they can do it".

Jason Zweig, in his famous article- "A matter of expectations" reveals that only 3% of the large U.S companies had grown by 20% for at least 10 years straight. Not a single one had done it for 15 years in a row.

In conclusion, a great company is not a great investment once you pay too much for the stock. That is the underlying concept.

The Proponents Of Social Media
Having disclosed my arguments above, there are plenty of investors with different opinions towards the market in general and towards social media stocks in particular. As always, one can always count on mainstream media to lead him exactly in the wrong path to riches. A fine example for this was the recent cheering by Jim Cramer, encouraging investors to wait expectantly to Facebook's IPO and "try to get a piece of the deal".

So What's An Investor To Do?
Shorting those stocks in the short run could prove to become a very risky endeavor. It is enough that another Facebook hype cloud passes along, to make those social media stocks shoot up, causing a short squeeze and forcing the short sellers to close their position by buying to cover at higher prices. Therefore, I do not recommend shorting social media stocks for now.

Simply avoid holding them, or sell them if you already happen to own them. That said, as you will see in my disclosure, I might initiate short positions in these three stocks in the next 72 hours. Different people have different risk tolerances. I am willing to take on this risk, but I can't suggest that others take on this risk if I don't know their individual situations.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in LNKD, GRPN, ZNGA over the next 72 hours.

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