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Zynga (NASDAQ:ZNGA) and Facebook (NASDAQ:FB) are still facing analyst downgrades and have recently disappointing business results. Despite this bad news and subsequent plunges in share prices, these social media companies are still not cheap and should be avoided by conservative investors.

Don't Bet the Farmville

Zynga, the gaming company that provides games on Facebook, is struggling to turn a profit for shareholders. Zynga went public in December and its stock has since dropped 70%.

Zynga is currently trading in a range between $2 and $3 per share, a range that is much lower than $15 per share price levels seen in March. Despite this lackluster performance, CEO and majority shareholder Mark Pincus refuses to sell, denying investors a way to cut their losses on this investment. Even should Pincus receive and offer of $10 a share, he has expressed his goal to keep the company independent and to remain as CEO for the rest of his career.

There is definitely a need for activist shareholders to rise up and advocate for change, but there is no way for other shareholders to credibly threaten the majority shareholder and CEO. Many stockholders are ready to cut their losses and sell this lackluster investment to a mainstream gaming company such as Take-Two Interactive Software (NASDAQ:TTWO), Electronic Arts (NASDAQ:EA) or Activision Blizzard (NASDAQ:ATVI). It remains to be seen what the minority stockholders can do to influence Pincus as Zynga struggles to grow as a company or to sell to another firm.

In July, Zynga posted lower than expected profit for the second quarter, precipitating a decline in share values. Zynga attributed this loss to Facebook's changing interface, which made Zynga's games less prominent and thus harder to locate. After Facebook's Timeline was released and slowly forced upon Facebook's users, Zynga's FarmVille, CityVille, and CastleVille lost more than 20% of their participants. Moreover, Facebook itself has lost value since it has gone public. The company has now made a new, more conservative estimate of share earnings for the 2012 year, scaling back its original prediction of 23-29 cents a share to four to nine cents.

Investors and analysts have not lost all hope for Zynga, however. Many look to the prospect of a new Chief Operating Officer to manage the company better and for the possibility of exploring other options in addition to Facebook through which to reach consumers. Additionally, Zynga tops its segment of the market in having the highest percentage of its market capitalization in cash and investments as a result of its lowering stock price.

Facebook's story is parallel to Zynga's. Facebook's CEO, Mark Zuckerberg, owns the majority of voting rights. Facebook stock has plummeted since its $38 per share IPO to nearly $18 per share, angering many IPO investors. Analysts are revising price targets lower, from $25 per share to $15 per share. Share prices may fall further as the lockup which prohibited early investors recently expired. Many of these shareholders will likely try to sell part or all their 271 million unlocked shares rather than wait for the stock to recover. An additional avalanche of 1.66 billion Facebook shares will become available for trading in the next nine months, with 1.2 billion to be unlocked in November of 2012. Many of the holders of these stocks invested early in the company, at much lower price points and are anxious to take a profit.

This injection of new shares into the market will likely send Facebook share prices down dramatically. Moreover, price declines in this flagship social media stock will likely drive other social media stocks like Zynga down.

Sobering Valuations

Huge losses for shareholders have not yet made either Zynga nor Facebook cheap. Consider the following valuation multiples:

Ticker

Company

P/E

Forward P/E

P/S

P/B

 

Take-Two Interactive Software

 

9.49

1.26

1.91

 

Electronic Arts

68.42

10.66

1.01

1.62

 

Activision Blizzard

16.44

10.89

2.94

1.23

 

Zynga

 

25.45

1.73

1.17

 

Facebook

106.06

28.66

9.45

3.07

Unfortunately, a trailing twelve month price-to-earnings ratio is not useful for Zynga because it suffered a loss over the past year. Hence, this key ratio is not helpful. The price-to-book ratio is treacherous for comparing stocks which have internally-developed intellectual property that is not recognized by the balance sheet. Moreover, since many of these firms have business models whose profitability is questioned, using the price-to-sales ratio is insufficient since it presumes that sales will eventually lead to earnings.

Instead, we are forced to use the forward price-to-earnings multiple for comparison. This valuation metric shows how Zynga is valued more like Facebook than it is to gaming software companies. Facebook and Zynga trade above 25 times forward earnings while Take-Two, Electronic Arts, and Activision Blizzard trade near 10 times forward earnings. Essentially, the market is posing the following question to investors: "Are you willing to pay 2.5 times as much for social media stocks than you are for conventional gaming companies?"

Since investors in the second half of 2012 are starting to consider traditional metrics like earnings or cash flows as requirements for valuing these Web 2.0 bubble stocks, the answer to this question should be a clear "no." Investors should require a discount to endure the volatility which will likely come from the addition of new Facebook shares to the secondary markets. Instead of buying shares in Zynga and Facebook, investors should consider buying shares of Activision Blizzard and Electronic Arts. Each company trades at much lower forward price-to-earnings multiples, and both are currently profitable companies.

Source: 2 Overpriced Social Media Stocks To Avoid Now