Evaluate social media IPOs on biz fundamentals

Amid the frenzy of billion-dollar valuations of social media companies that have or have yet to go public, market experts unanimously emphasize one fundamental universal rule--scrutinize business model, revenue and profitability potential when assessing the value and viability of the organization that's getting listed.

News of LinkedIn's May 19 debut on the New York Stock Exchange, which valued the seven-year-old social network at over US$4.2 billion, had fuelled anticipation--and anxiety--around the valuations of other social media bellwethers in line to go public. These include Zynga, valued between US$15 to 20 billion, and Groupon, valued at US$25 billion. Social network juggernaut Facebook, rumored to be going public next year, has been valued a whopping US$100 billion.

Michael Yoshikami, CEO and founder of YCMNET Advisors which is based in the San Francisco Bay Area, said whether or not social media businesses are indeed worth their high initial public offering (IPO) valuations "really depends on the company" itself.

It is possible that LinkedIn and Facebook deserve a very high valuation because they both have strong business models, he noted. "However, [for] companies like Twitter, it is a little harder to see how the valuations can be justified", Yoshikami told ZDNet Asia in an e-mail.

Groupon, for instance, has a business model that is easily replicated and currently operates in the red, he said, but added that the group-buying site is still attempting to go public at a very high valuation.

Evaluate business model, profitability
"Only profits will justify a stock price in the long term," Yoshikami explained. "Just because a company is a social networking firm does not ensure profits; that's the bottom line. Profit is key."

He pointed to News Corp's US$35 million sale of MySpace in June, which is a fraction of the US$580 million it spent in 2005 to acquire the social networking site.

Nathan Birch, director of strategy group at advisory firm KPMG Australia, highlighted that much of the current social media valuations and speculations are based on future earning potential, as opposed to historical revenue or profitability.

In a phone interview, he emphasized the "fundamentals" of scrutinizing the individual social media company's business model and profitability.

Birch said: "There are companies that have sound business plans, real revenue and real profits, like Facebook, or a clear vision of real profits like LinkedIn. If we talk about valuations of those companies, then actually I would say they're not overvalued."

He noted that when search giant Google made its stock debut in 2004 at US$85 a share, market watchers also said declared that it was "massively overvalued". "[Google today is] trading somewhere around US$500 a share. If anything, it was undervalued," the Melbourne-based executive said.

Laurence Booth, finance professor at University of Toronto's Rotman School of Management, argued that social network sites are not worth their IPO valuation because most have no barrier to entry.

"Google or even Microsoft can replicate or buy them out," he said in an e-mail interview, adding that some have bad business models. Group-buying sites, for example, are simply giving away coupons electronically and are facing other competitors, added Booth.

"All too often people forget to ask the basic question, 'what can these guys do that others can't, so what am I paying for?'

"The fact is most social media sites can be easily copied at a much lower cost than their market values, which makes them extremely vulnerable," he explained.

Risk of being smitten by social
Max Loh, country managing partner at Ernst & Young Singapore, pointed out that investors risk getting "carried away" with the notion that social media is the next big thing and any valuation of social network sites can be justified.

Ronan Gruenbaum, professor of digital marketing at London's Hult International Business School, had this advice: "Do not invest in social. Invest in potential and invest in profit."

He reminded that the Internet bubble of the 1990s grew out of a "mistaken belief" that any company that had a dot-com business was guaranteed to make millions, if not billions. Similarly, today, there are people who think any company vaguely involved with social media--the buzzword of the past few years--will be a guaranteed success, Gruenbaum noted in an e-mail.

He reiterated that what is critical is whether the company has a sound business model and the management to deliver that strategy, such as the ability to make money from its customers, whether it is premium subscriptions, micropayments or targeted advertising.

Twitter, he said, is an example of a company that created a community but "didn't think about the business model". Created in 2006, the microblogging site did not offer advertising as a revenue generator until April 2010.

It was fortunate to have enough angel and venture capital investors willing to take a risk on the company, he noted, so Twitter is likely to continue until it can further develop its nascent advertising platform and make a profit from it.

According to Michel Birnbaum, general partner at Singapore venture capital firm iGlobe Partners, while social networks have a definite value given their fast-growing, large user base, business rules always apply regardless of the innovation or disruptive technology.

"Once the dust settles [after the hype], the companies that survive are the ones which were able to leverage their customer base, visits or pageviews, and generate sustainable revenues and growth," he told ZDNet Asia in an e-mail.

IPO neither guarantee nor end in itself
Birnbaum added that investors need to look at the metrics used to arrive at a valuation, and if such metrics make sense and depict the reality of the business. He noted that there could sometimes be misuse of accepted metrics and accounting methods which, for example, was the case for Chinese social network, RenRen.

According to various reports, the Chinese company was unable to verify the accuracy of its user numbers and also had insufficient accounting personnel.

Ultimately, Birnbaum pointed out, going public is not an assurance that a company will be successful, even if it has access to large pools of capital from the capital markets.

A lot of the social networks which have gone public or are scheduled to go public will have a "tough time" matching investor expectations, unless they are able to develop viable and sustainable revenue growth models.

"The honeymoon will be short-lived", he cautioned.

Agreeing, Loh from Ernst & Young Singapore, highlighted that achieving an IPO merely serves as a platform for further investments and growth. Being publicly-listed does not guarantee continued financial viability if the business model is unsound or strategies are not executed properly, he said.

He noted that it is "natural" for investors to be excited about high growth potential businesses, as seen with social media, but in the long term, "fundamentals must hold sway"--the need to understand their business and plans for growth and profitability.