The Social Media Bubble: Facebook Just Bought Instagram for $1 Billion

No matter who you are, one billion dollars is a ton of money.  But to Facebook, this is barely 1% of it’s estimated $100 billion value.  Facebook’s looming IPO has drawn Google like valuations of the soon to be public company.  This most recent absurd purchase is the latest to define the social media bubble.  Social media valuations are becoming more and more ludicrous.  Instagram is a photo sharing app(that most people already use through Facebook!) based out of Silicon Valley and has a grand total of 13 employees.

The thing that strikes me most about these valuations is the implied growth and monetization of users.  How is Facebook worth $100 billion?  Potential.  Facebook boasts 845 million active monthly users, an active growth rate and a 27 percent profit margin(comparable to Google’s 26 percent).  The big question though is, can Facebook maintain it’s growth rate and how does it plan to make more money from it’s existing users?  Personally, I use facebook primarily on my mobile device, and they don’t even advertise yet on that platform.  

What is a Bubble?

An economic bubble could be described as a dramatic increase and decrease in valuation of certain products or assets.  I am certain we are approaching the halfway point to a social media bubble. There is a basic fundamental value to every asset and when the bubble bursts, these assets will return to their more natural values.

An example would be the dot-com bubble of the late 1990′s.  Investors saw record setting growth and projected earnings.  They ignored traditional metrics like P/E(Price to Earnings Ratio) and took more risks than normal in the hopes of extraordinary returns.  Many dot-com strategies relied on operating at a net loss in order to build market awareness.  During these periods of loss, companies relied on venture capitalists to fund operations and IPO’s to bring in much needed cash.

Does This Sound Familiar?

We are in the exact same situation now.  There’s nothing inherently wrong with social media companies, but they have become the focus of a crazed fascination with unsustainable valuations and outrageous IPO’s.  Social media is just another investment fad.  Companies like Instagram, Linkedin and Groupon are the perfect examples of overvalued assets.

P/E Ratio Explained

Linkedin has an insane P/E Ratio of 1314.  The Price to Earnings ratio is one of the numbers that “number crunchers” use to see how much a company is actually worth.  The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share.  An example:

If Company X makes 50 cents a share in profit and the price of the stock is 10 dollars, then the P/E ratio is 20 – the stock is 20 times as much as the profit per share.  You could say it would take 20 years to pay back the purchase price.

Stocks with higher P/E ratios tend to be overpriced, but the important thing is to compare P/E ratios within the same sector.  Facebook’s valuation isn’t as easy to determine, but let’s say it’s worth $100 billion.  Their estimated 2011 earnings were $4 billion.  So assuming $4 billion in sales and a $100 billion valuation, we arrive at a P/E ratio of 25.

Facebook and Twitter are likely here to stay, but it’s clear that the social networking sector is ripe for a crash.  It’s not clear when or how it will occur, but history shows that current valuations are not sustainable for very long.

Do you think Facebook is worth $100 billion?  Do you plan on investing in social media sites or is it too late?

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Hi, I'm Harry, the owner and head writer for Your PF Pro. I started this site back in 2011 in order to create a place where young professionals could come and get all of their financial questions answered. On the site, you'll find articles on everything from asset allocation for retirement to saving money at Chipotle! So enjoy..

Comments

  1. Matt says

    I was reading your article with CNBC on in the background and they started talking about the possibility of a social media bubble!! Good call!

    I don’t plan on investing in social media (at last not right away) because I think that everyone is going to buy into it, making the price too high. Parents will buy Facebook stock for their kids, regardless of the price. College kids will buy it and brag about it, etc.

    That being said, it does have some great business characteristics. If someone tells me they’re not on FaceBook, I think it’s a bit weird (which is stupid, I know). It’s as if you NEED to be on FaceBook in order to be normal. It has a monopoly on our social lives. Companies also need to be on FaceBook. Most commercials I see, both on TV and in print, advertise their own FaceBook page. That’s free advertising for FaceBook!

    I also love that Zuckerberg wants to make more money in order to make a better social network, rather than the other way around. That will mean that he always has the incentive to make it better, and will never be satisfied. For investors, that means he will always need more money. I think he’s smart enough to find a way to get it.

    Lastly, if you gave someone $10 billion, they still couldn’t compete with FaceBook. That’s a high barrier to entry: just like Coke when Buffett bought it.

    If the price was lower, I would buy. But paying over 100x earnings is too pricey. If I miss out on profits, then I’ll still feel I made the right call by avoiding unnecessary risk.

  2. says

    Thanks Matt, all good points. I don’t think Facebook is going anywhere soon, but social media is a fad in the investing world right now. It doesn’t take a genius to see that Instagram isn’t worth a billion dollars. I wasn’t a big investor during the last bubble, but from everything I’ve read, the signs are exactly the same.

    “Those who cannot learn from history are doomed to repeat it.”

  3. Matt says

    I just came across a recent article about impulse buys via Facebook shares and “likes.” It could mean that advertising via Facebook may be enticing for businesses, meaning more $$$ for Facebook.

    Also, another note on Zuckerberg’s purchase of Instagram: He turned down a job at Microsoft out of high school to attend Harvard, then started a Fortune 500 company in his dorm room as a teenager. I’m willing to accept that he MAY be smarter than me (sarcasm). So, though I would never argue that it’s definitely worth $1 billion simply because Zuckerberg, the genius, thinks it is, I certainly wouldn’t bet against it. Going against Zuck would scare the crap out me. Though some really smart people failed to see the housing bubble, I just can’t assume Zuckerberg is that delusional about social media.

    You’re right, though. It’s got all the symptoms of a bubble. I’m gonna sit it out and see what happens. I’m like you: I can’t buy high P/E stocks. I also can’t bet against them when the smartest people in the world are on the other side of the bet, though.

  4. says

    There are definitely some opportunities FB will be exploring to make more money through advertising. My total market funds will be invested in FB and all of the rest of the social media stocks so I’m not too worried about missing out on it :)

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