Social media companies have become the new heavyweights of the technology world, with markets giving massive premiums to companies such as LinkedIn and Facebook, while industry stalwarts like Apple and Microsoft struggle to keep up. But is the bubble about to burst?
Some say that it already has. Facebook's stock has fallen by 16.5% since its initial public offering in May, which valued the company at $104 billion. Share prices began falling almost immediately after the float, with many analysts warning that the company was heavily overvalued – pointing to its unproven ad revenue model.
Facebook makes money by charging companies a fee to show adverts designed to attract new “likes”. However, a BBC investigation published this week suggests that many if these likes are from fake accounts run by computer programs to spread spam.
Facebook claims it has not seen evidence of a significant problem, but the story raises further questions about the value of the company's ad model. Several technology companies are already suffering in the wake of Facebook's IPO, and it is thought that the whole affair will make it a lot harder for the next social media company to go public.
Meanwhile, the news emerged today that news-sharing website Digg – once valued at more than $160 million – will be sold to technology investment firm Betaworks for just $500,000 (£324,000). The company plans to return Digg back to startup mode with a low budget, small team and fast cycles, but that will be a difficult transformation to make.
Signs that the social media economy is a bubble were around long before Facebook's IPO. Deals site Groupon raised $700 million in its November 2011 IPO, but is being sued for allegedly misleading investors about its financial prospects, and shares have now tumbled to a record low.
Zynga, the games company behind FarmVille and Words with Friends, also bombed on its first day of trading, and has since seen its stock sink to under $5 per share.
“The social media bubble is so much like the internet bubble of 1999/2000,” said TechMarketView analyst Richard Holway.
“We are sure that a tiny bunch of companies will survive and prosper to become the new Amazons. But the vast majority will either fail or be ‘rescued’ in garage-sales for a fraction of the investment poured into them.”
There is one exception, according to Holway: LinkedIn.
When LinkedIn went public in May 2011, its IPO share price was $45, but that figure has since soared to over $100. It has been able to attract investors because its business model is much closer to an enterprise business model than a consumer one.
“Whereas Facebook relies mainly on advertising, Linkedin doesn’t really need advertising,” Holway said. “Facebook hasn’t really worked out its mobile model – Linkedin is just as effective however you access it; Facebook generates $0.06 per member per hour, Linkedin generates $1.30 per member hour – 21x more.”
However, Victor Basta, managing director of merger and acquisition consultants Magister Advisors, said that the company is still vastly over-valued, highlighting that both LinkedIn and Facebook have price/earnings (PE) ratios many times higher than Apple and Microsoft.
LinkedIn has a PE ratio of 711 and Facebook has a PE ratio of more than 70; Apple has a PE ratio of 14.5 and Microsoft has a PE ratio of 11.
Magister Advisors said that if Apple – a business with enormous brand value and a world-class track record of execution – received the same valuation as a business like Facebook or LinkedIn, it would be valued at many trillions of dollars.
“Achievement is being punished. Unproven future value is worth more than achievement,” said Basta. “LinkedIn and Facebook are incredibly important next-generation internet businesses, but it is absurd to believe they are worth several times, or even several hundred times more than companies that already dominate their sectors.”
He said that, while Apple and Microsoft have challenges to keep growing as quickly as the internet giants, companies like Facebook have their own growth challenges, as they encounter privacy concerns, and try to make money from their mobile subscribers.
“The technology industry has always over-valued the next big thing, and some of this ‘irrational exuberance’ is perhaps understandable. But where is the value for decades of performance?” said Basta. “It is only in the technology industry that a bird in the bush is worth far more than a bird in the hand.”
This is not to say that all social media companies will fail. What they must do eventually, however, is make money.
Often this means using a tried-and-tested business model – as LinkedIn has with its new-age recruitment service. Amazon also survived the first internet bubble because it has a timeless business model which was adjusted to meet the latest delivery mechanisms, according to Holway.
For the VCs that specialise in technology there are few illusions. They are taking a punt on the ideas and concepts that excite them, and the transformative power of IT means that one success can more than justify scores of failures.
Nevertheless, it is cash, not concepts, that motivate the VCs and the best way for any start-up, whether it be a social media company or not, to raise cash or to avoid falling foul of the bubble economy is to prove it is financially credible from the start.