Facebook, LinkedIn Not Offering Value At Current Prices

Includes: FB, MSFT, SOCL
by: Prashanth Jnanendra

The listing of Facebook (FB) and the subsequent fiasco at NASDAQ merits a look at the valuation of social networks in general. Fundamentally, what is a social network? Linkedin's (LNKD) prospectus talks about it in crisp terms as "a platform, members are able to create, manage and share their professional identity online, build and engage with their professional network, access shared knowledge and insights, and find business opportunities". Of course, this is applicable only to Linkedin as it talks about professional identities. In similar terms, Facebook's prospectus espouses that people use it "to stay connected with their friends and family, to discover what is going on in the world around them, and to share and express what matters to them to the people they care about"

Going by the logic above, it would imply that people care about family and friends "news" as much as they do about other worldly "news". For instance, Joe liking steak at new restaurant and Jane getting promoted to Senior Manager is as much "news" to their friends and family as is the US presidential race. Perhaps, social networks can be viewed as customized newspapers, in this regard? Customized because, as a user, I can get only as much news as I want or have access to. That is, if I do not know Jane or Joe, I will not bother about their likes or "news" either.

Furthermore, like newspapers, the social networks derive a bulk of their revenue from classifieds or advertising. Linkedin's March ending quarter had $150mn (almost 80% of $188mn) as revenues from what it calls hiring and marketing solutions. These comprise job postings and advertisements. Facebook's March ending quarter had $872mn (over 80% of $1,058mn) as advertising revenues. Clearly, in this regard, the social network is very much like a newspaper.

In another aspect too, the social network is similar to a newspaper. In the economic landscape of newspapers, one newspaper tends to dominate over time (in a town or so). As Michael Mauboussin points out in his book 'Expectations Investing', "demand tends to take off when a company forms a network that reaches critical mass, that is, the point at which enough people use a product or service to catalyze self-sustaining growth." Warren Buffett points out more succinctly that people will never prefer a thinner newspaper offering fewer ads. And advertisers will choose the dominant newspaper to maximise their reach. The similarity extends to social networks too. After all, why would I use MySpace or Orkut when all my friends use Facebook? And why would advertisers move to another social network when they can maximize their reach just by sticking with the dominant one?

So, if social networks are similar to newspapers, shouldn't they be valued similarly? Perhaps, at lower multiples too, as Bill Gates had pointed out in an interview in 1998, "I think the multiples of technology stocks should be quite a bit lower than the multiples of stocks like Coke, Gillette, because we are subject to complete change in the rules." Gannett Co (GCI) trades at P/E of 9, News Corp (NWSA) trades at P/E of 16 and Washington Post (WPO) trades at P/E of 26. Shouldn't the street take a clue and revise the multiples of Facebook (currently at P/E of 100) and Linkedin (currently at P/E of 670)?

As investors, what we look for is "bang for our buck". Two metrics that could help are Return on Capital (that is EBIT/{Net Working Capital + Fixed Assets}) and Earnings Yield (EBIT/Enterprise Value). This approach has been popularized by Joel Greenblatt in his book "The little book that beats the market".

Return on Capital % Earnings Yield %
FB 1756/(4604-899+1475) 33.8 1756/61490


LNKD 26/(726-226+114) 4.2 26/10980 0.2
GCI 831/(1076-901+1640) 45.8 831/3480 23.8
WPO 296/(1246-996+1152) 21.1 296/2750 10.8
NWSA 4752/(20124-9402+5940) 28.5 4752/53250 8.9

So, while FB yields a fantastic 33%+ on RoC, it is priced too high to yield "decent" earnings. LNKD disappoints on both the counts.

In summary, investors will not find "bang for their buck" by investing in FB or LNKD.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Note: Data in the table is for the year ending Dec 2011.