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Posted on 10 March 2013 | 5,610 views

Are Social Networking Stocks Ready For a 2011 Crash?

The share price of the professional social networking company more than doubled in its first day of trading on May 19 after its initial public offering price at $45 a share.

Investors who believe “LinkedIn” is overvalued after its explosive market debut last week may get their first crack at proving that Friday May 27, 2011 when options in the stock start trading on U.S. exchanges. LinkedIn (Stock Symbol: LNKD) managed to sell itself to the public during the late stages of the 2011 Bubble formation but well before the inevitable bust.

At the peak of the tech bubble in 2000, the Price/Earnings ratio of the NASDAQ 100 was well in excess of 200. In other words, people were happy to pay more than 200 times annual earnings for the companies in the index. Even in the extremely unrealistic case that earnings double every year, it would take about 8 years to get paid back. That is why the bubble popped. Today the P/E for the NASDAQ 100 is 17.4, a sustainable value.

LinkedIn currently has a P/E ratio of 1314. Even in the unlikely event that earnings double every year, investors would need 11 years to recoup their investment.

Other valuation measures are equally absurd. The Price to Sales ratio is 13.5 and the Price to Book ratio (measures the stock price vs. the company’s assets) is 132. The NASDAQ 100 trades at a P/S ratio of 2.2 and a P/B ratio 3.5 for comparison.

LinkedIn is vastly overvalued, even compared to the famous irrational exuberance of the last tech bubble.

A similar picture emerges for Facebook. Its valuation isn’t as easy to determine because it is privately held but by most accounts it is worth somewhere between $50 billion and $150 billion. The 2010 sales are said to have been around $2 billion and they are expected to double in 2011. Assuming $4 billion in sales and a $50 billion valuation, we arrive at a P/S ratio of 12.5. Higher valuations or lower sales would increase this already completely absurd number.

Irrational exuberance has clearly returned to this component of the tech sector. No doubt we will soon hear that ‘it is different this time,’ and we may even see a return of absurd valuation measures like ‘Price to Eyeballs.’

LinkedIn and “Facebook” would have to find a way to increase their sales tenfold in a very short period of time to support their current valuations. This is virtually impossible to do for these large and relatively established companies.

Other stocks investors are keeping an eye on is a Twitter and Groupon initial public offering along with Yandex (Stock Symbol: YNDX), Sina (Stock Symbol: SINA), Dex One (Stock Symbol: DEXO), SuperMedia (Stock Symbol: SPMD) and Local.com (Stock Symbol: LOCM).

The “Social Networking” sector is ripe for a crash, just like the whole tech sector was in early 2000. It is not clear when, or how it will affect individual companies, but history shows that current valuations in this sector as a whole are unsustainable for long periods.

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