Posted on April 7, 2011 by Ben Connard

Social media companies are the next big investment according to the valuations attached to these stocks. Groupon (a group coupon company) turned down Google’s $6 billion offer and Facebook was valued at $10 billion in 2009. Now Groupon is looking to IPO for $15 billion and Facebook is said to be worth $50 billion. Twitter, which is expected to earn a little over $100 million in revenue this year is valued at $10 billion. 

Can Facebook, home to the candid photo and critical updates (Ben just finished his run, he’s tired), generate the cash to justify the valuation? Facebook, like most social media, earns money through advertising. Its value lies not only in the sheer number of users (500+ million) but the intimate knowledge it has of its users. Facebook can track every time you “Like” something, compile that data and get an excellent consumer profile. It can feed the information to advertisers so they can better target their ads. The better targeted the ad, the more money Facebook gets per impression.

Growing the users and the cost per impression fast enough allows investment bankers to assign a $50 billion valuation pretty quickly. Of course, Fox News Corp tried a similar approach with Myspace and that didn’t turn out well. Myspace once had more than 5 billion visits per month in the US and it’s now down to 200 million. Facebook has surpassed Myspace’s peak (it now has more than 9 billion visits per month in the US) but if it starts inundating its users with ads, people may flee. Fickle teenagers could also simply determine that it’s not cool anymore and head to another site where their parents don’t have a page.

Twitter’s estimated revenue gives it a price to sales multiple of 100. Google trades for a P/S ratio of 6.5. Search “running shorts” on Twitter and up pops a tweet from Adidas. Google running shorts and up pops a link to Adidas. Of course, when users search on Google or Microsoft’s Bing, they expect ads. Twitter users will have to get used to the idea of advertising tweets showing up in their stream.

Groupon’s rejection of Google’s offer created greater awareness of the company. Since the company has become a big hit, more than 500 imitators have popped up. The second largest is Living Social with 16 million members (Groupon has 44 million). Facebook has started a “Deals” app. Opentable, another high flying company trading at a P/E multiple of 188, has started its own coupon segment. It takes reservations for restaurants and a natural continuation is to start selling coupons to those restaurants. In some ways, these coupons are more valuable to restaurants since their members are more targeted—they made a reservation at the restaurant (or one like it) in the past.

The social media companies have an impressive number of users that keep growing. And they may reach a critical mass where they become unstoppable forces—Facebook could be approaching that number. On the other hand, barriers to entry are key to a company’s long-term survival. It allows a company to preserve its margins and generate cash, as opposed to having to continually lower prices to undercut its competitors. It’s not the best sign that more that 500 competitors popped up for Groupon once Groupon became successful. Google has also started a +1 feature similar to Facebook. The companies might also have an easier time if they were able to charge users for their products.

The bottom line is social media provides a new platform for communication and provides exciting avenues for entertainment. However, I’d like to see these companies generate cash and prove themselves against competitors before I awarded Facebook a valuation similar to 3M’s.