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Investing in Social Media Stocks

Wall Street was abuzz recently with the IPO of the business-focused social network, LinkedIn.

The company received enormous attention as the first in a wave of US social networking and Web 2.0 companies set to go public. This wave will include the likes of Facebook, couponing company Groupon and social games service Zynga.

To describe it as a successful IPO is putting it mildly as its shares doubled in their first day of trading. With a valuation in excess of $8 billion, LinkedIn is trading at 30 times its revenues of $243 million for the past 12 months and over 170 times its cash flow.

A stunning valuation to say the least for a company born in 2003. And a valuation that had Silicon Valley investors feeling giddy.

If Facebook were given the same valuation level, it would be valued at more than $60 billion. The discount coupon business Groupon would be worth $25 billion.

A Closer Look at LinkedIn

Why were investors willing to pay so much for LinkedIn? Good question.

The most likely answers are the very limited number of shares – 7.8 million – offered and short-term traders.

For longer-term investors, LinkedIn doesn't look like a value proposition.

The share structure of LinkedIn actually has much in common with the share structures of both Google and Chinese social media company Renren.

All three companies have a dual voting structure. New investors will have only a fraction of the votes attached to existing shares held by company insiders and its initial investors.

This arrangement does provide protection against hostile takeovers. But it does ensure that near-complete control of the company remains with the founders, employees and venture capitalists.

In effect, corporate governance is weak...the average public shareholder doesn't really count. His or her only purpose is to drive the share price higher for the benefit of the original shareholders.

Companies like LinkedIn must love the day traders who don't care about anything longer term than a day or a week at the most.

But LinkedIn is not alone. Many other companies in the sector have adopted similar share structures.

Social Media Sector

What should investors think about the social media sector as a whole?

Warren Buffett, who has long shunned the tech sector, spoke about social media companies a few months ago. He said, “Most of them will be over-priced...Some will be huge winners, which will make up for the rest.”

Based on history from over a decade ago, he is right. For all the many internet dogs like Pets.com which soon disappeared, there were some big winners like Priceline.com.

As long as social network companies are growing and pulling in millions of new members, such as Facebook and Twitter, they have great revenue potential.

But when growth stalls, or even slows, things tend to go bad quickly. Just look at MySpace or Friendster, the pioneer of social online networking in 2002.

Both Facebook and Twitter are clearly worth some number of billions of dollars. Facebook is now the world's leading social network with more than 500 million active users and estimated advertising revenues of about $2 billion last year.

Consultancy eMarketer says Twitter last year had revenues of $45 million. And the company had zero overseas revenue...which clearly means it has room for growth there.

Even the bears on social media have to agree that more advertising dollars will flow into social media companies as marketers adjust to the shift in online consumption. The only question will be how many advertising dollars will flow. After all, many users go to social networks to socialize, not to buy something.

Investing in Social Media

If someone decides to invest into social networking companies, they must remember that they are betting on the cash flows of these businesses not only expanding rapidly but turning out to be sustainable.

During the tech bubble, many of these businesses turned not to be sustainable. But will it be different this time?

Many who believe it is argue that much has changed since the last time. And they make some valid points.

Far more people globally are connected to the internet, There are an estimated 2 billion online users today compared to only 248 million in 1999.

And this time the frenzy was ignited somewhat more rationally – by profit generation within the growing connections between social networking, gaming and other social phenomena.

That narrower focus should limit the number of companies coming to market and hopefully limit most of the IPOs coming to market to the higher quality companies.

As with any new issues, potential investors into this sector need to exercise their due diligence. The prospectus of LinkedIn with its 19 pages of 'risk factors' point that out.

Go ahead and invest in social media stocks. Just do so with both eyes open.

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