Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Facebook Inc (FB), LinkedIn Corp (LNKD): Should You Buy Social Media Stocks?

Jeff WeinerFacebook Inc (NASDAQ:FB) shares exploded to the upside on July 25 after reporting excellent quarterly earnings, redeeming those who stuck by the social network since the company’s famously disappointing initial public offering.

Social media stocks, including peers LinkedIn Corp (NYSE:LNKD) and Yelp Inc (NYSE:YELP), have been on fire over the past few months. There seems to be no end to either the amount of investor optimism surrounding these companies, or the valuation multiples investors are willing to pay for the privilege of ownership of these stocks.

While it’s undoubtedly true that Facebook Inc (NASDAQ:FB) just wrapped up a great quarter with strong growth in nearly all the metrics that are important to the company, in my estimation, the stock’s valuation and growth expectations are beyond reasonable levels.

A social media bubble?

After perhaps the most closely watched IPO of all time last year, the excitement surrounding Facebook Inc (NASDAQ:FB) quickly turned to despair. Investors saw the company’s share price collapse from $38 to $17 in four months.

Fortunately for investors, the stock had already recovered very strongly leading into earnings, and shares continued to soar after releasing its quarterly results. In all, Facebook Inc (NASDAQ:FB) stock skyrocketed around 30% on the day following its earnings announcement.

That’s because the company unleashed a huge quarter, with earnings of $0.19 per share, beating expectations by a nickel and easily topping last year’s $0.12 per share in second-quarter 2012 profits.

Revenue grew 53% year over year, to $1.81 billion, far exceeding analyst estimates, which called for $1.62 billion.

Broad optimism was also fueled by the company’s successful transition to mobile. In the second quarter, 41% of advertising revenue was from mobile, up 11 percentage points quarter over quarter. Again, this metric blew past expectations.

LinkedIn Corp (NYSE:LNKD), something of a Facebook Inc (NASDAQ:FB) for professionals, exchanged hands for $93 per share after its heavily publicized 2011 initial public offering. Since then, the stock has gone on a nearly uninterrupted run to $200 per share.

Along the way, LinkedIn Corp (NYSE:LNKD) has piled up active users, and as a result, revenue. As of the company’s last quarterly results, the website boasted more than 225 million members. Moreover, LinkedIn Corp (NYSE:LNKD) booked 72% revenue growth in the first quarter, year over year.

LinkedIn Corp (NYSE:LNKD) also generated huge growth in full-year 2012, with revenues and diluted EPS skyrocketing 86% and 72%, respectively.

Yelp Inc (NYSE:YELP), meanwhile, has seen its share price soar beyond even the most generous expectations.

I last wrote about Yelp Inc (NYSE:YELP), the online guide for information and reviews of popular places of interest, in April. At that time, Yelp Inc (NYSE:YELP) exchanged hands for $25 per share, exactly where it ended its first day of trading when it went public last year.

Shares took off since I last wrote about Yelp Inc (NYSE:YELP), breaching $40 per share recently. Yelp Inc (NYSE:YELP)’s meteoric rise is particularly perplexing, given the company’s inability to turn a profit. Yelp reported losses in fiscal 2012 as well as the first quarter of 2013.

Growth at an Unreasonable Price

In investing, there’s a strategy known as GARP, which stands for growth at a reasonable price. In short, it relates to growth investors who look for companies showing strong underlying growth in revenue and profits whose shares still trade for reasonable multiples.

That last statement contains two important pieces: demonstrable growth, and a reasonable valuation. I believe Facebook Inc (NASDAQ:FB) has the former; the latter, however, just isn’t there.

Facebook earned one penny per share last year and $0.46 per share the year prior. Obviously a stock that earns one penny per share will have a ridiculous P/E. But, even on a forward basis, the valuation is lofty: Facebook trades for a forward P/E of nearly 50 times.

As far as LinkedIn Corp (NYSE:LNKD) is concerned, the company amassed a grand total of $0.19 per share in diluted earnings last year. That means that investors are paying more than 1,000 times 2012 earnings.

Like Facebook, LinkedIn and Yelp are both aggressively valued, even when you take strong future growth into account. LinkedIn and Yelp trade for forward P/E multiples of 90 and 230 times, respectively.

To be clear, I absolutely recognize the strong growth each of these companies is realizing currently. At the same time, valuations have risen so far, so fast, that even when assuming huge growth rates going forward, the odds of shareholders winning over the long-term aren’t in the investor’s favor.

These web sites undoubtedly have hundreds of millions of satisfied users and loyal fans. And, I can’t possibly say for certain that social media is the next bubble waiting to burst. What I will suggest, however, is that these stocks are not nearly profitable enough to justify the massive valuations they enjoy.

Facebook is now an $80 billion company by market capitalization. It’s rarely advisable to pay 50 times forward earnings for such a large company. These social media stocks are simply too risky for prudent long-term investors.

The article Should You Buy Social Media Stocks? originally appeared on Fool.com and is written by Robert Ciura.

Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Facebook and LinkedIn. The Motley Fool owns shares of Facebook and LinkedIn. Robert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

DOWNLOAD FREE REPORT: Warren Buffett's Best Stock Picks

Let Warren Buffett, George Soros, Steve Cohen, and Daniel Loeb WORK FOR YOU.

If you want to beat the low cost index funds by 19 percentage points per year, look no further than our monthly newsletter.In this free report you can find an in-depth analysis of the performance of Warren Buffett's entire historical stock picks. We uncovered Warren Buffett's Best Stock Picks and a way to for Buffett to improve his returns by more than 4 percentage points per year.

Bonus Biotech Stock Pick: You can also find a detailed bonus biotech stock pick that we expect to return more than 50% within 12 months.
Subscribe me to Insider Monkey's Free Daily Newsletter
This is a FREE report from Insider Monkey. Credit Card is NOT required.