Market Pricing Uncertainty: The Reason To Avoid Social Media Companies

by: Kevin Quon

As the investment world became captivated by the flurry of initial public offerings for large social media names in 2011, internet-based companies have once again become a hot topic to chase after. The commotion over access to this new frontier had opened the door to successful offerings found by social giants such as Zynga (ZNGA), Zillow (Z), Angies List (ANGI), LinkedIn (LNKD) and Groupon (NASDAQ:GRPN). Founded on the basis of popularity itself, such companies were bound to find a wide audience of investors looking to own a fraction of the growth opportunity.

In an expression of crazed fanaticism that emphasized both an inability to properly price the underwritings and a sense of fervor driving investors to claim ownership to such popular names, share prices of these companies fluctuated greatly on their first day of trading. By their first trading day's end, LinkedIn had closed 109% higher than its pricing, Zillow closed 79% higher, Groupon closed 31% higher, and even Angie's List closed 25% higher. Only Zynga failed to surprise as the company closed down a meager 5% from its IPO pricing. Such pricing discrepancies served as clear testament to the overwhelming excitement found in what had been an untapped market.

Yet just as the underwriters struggled to find an adequate means of valuating these popular growth entities, the market too has thus far had difficulty in providing a fair valuation for these new companies. With increasing bouts of high volatility in the past year, traders with long and short positions have fought to control the direction of these stocks. Such heavy swings of over 30% in both directions over the past year can be seen in the following charts for Groupon, Zillow, and LinkedIn.

Its for this sole reason of market pricing uncertainty, that investors looking to take ownership in these companies might fair better in sitting on the sidelines of these social media names until a more stable market trend can be determined on the basis of a fair evaluation of their growth potential. As is, many of these companies continue to trade on very high multiples that not only expects future growth, but relies entirely on the reality of such possible growth in order to justify current pricing. The following table takes all values as of February 8, 2012.

Company Price Fwd. Earn. Est Fwd. P/E.
Groupon $24.58 $0.31 79.29
LinkedIn $76.54 $0.57 134.28
Angie's List $16.27 ($0.79) N/A
Zillow $32.28 $0.30 107.60
Zynga $13.69 $0.22 62.23

Such high price-to-earnings ratios for these companies often leads to severe jolts in their share prices when analyst expectations aren't met. Good news suffers when it isn't great news. Groupon's earnings release this past Wednesday serves as an excellent reminder that there are very high growth expectations built into the current share prices. As a company that was trading at a $15.6 billion valuation prior to Thursday's market open, Groupon has yet to prove itself as a profitable entity. As a result, what may have easily been read as a mild miss for most companies, can have a disproportionate & eye-opening effect on the performance of the company's stock. In the after-hours trading session on Wednesday, Groupon's shares dropped over 15%.

Investors looking for continued growth in the social realm would likely fair better as a whole by investing in companies that have proven to be steady leaders in their respective industries. Both Apple (AAPL) and Google (GOOG) have already made lasting impacts on the evolution of technology and bear the fruits of dabbling in the social nature of interconnectedness. Not only have both companies become empires in mobile communications, but Apple's cult-like following has created its own social branding and Google's launching of Google+ offers a direct channel to tap into the social market. Additionally, as Apple currently trades with a forward P/E of 10.14 and Google trades with a forward P/E of 12.26, both companies are far cries from the overvalued expectations typically seen in the technology sphere.

Therefore, while the attraction to social media plays may appear thrilling at best, such companies continue to have considerable growth already factored into their stock prices. Investors wanting to truly reap the reward of a successful company, might just fair better in sticking to the ones that have already made names for themselves. Until the market sorts out what truly is a more fair valuation for the ongoing social craze in question, there's really just a greater sense of gambling going on than there is investing.

Disclosure: I am short GRPN.