The Social Media Bubble

Social media companies like Twitter are getting huge valuations. But are investors getting in on a boom or setting up a bust?

Is the social media bubble soon to burst?

If worry over a bubble can be enough to prevent it, then there are signs of hope in the portentous coverage of social media. Last month, Britain’s Daily Mail reported that high valuations for Facebook had set off a “feeding frenzy,” warning that cash-rich investors could be “inflating a multi-billion dollar social networking bubble.” The Wall Street Journal described the market as “increasingly frothy,” with venture capitalists circling Silicon Valley start-ups. And most ominously, CNBC’s Mad Money host and screamer, Jim Cramer, is telling viewers to leap in: He predicted a “valuation revolution” in social media. Business Insider noted, “It feels like 1999 all over again.”

Could it really be the dot-com bubble all over again—except this time centered on social-media companies? Perhaps. But there are some glimmers of prudence in this frothy market, meaning maybe we don’t need to worry about bubbles just yet.

In the past year, investors have shown tremendous interest in a tossed salad of companies, all “social” in some way or another and all gaining users at a blistering pace. Some of those start-ups have received investments valuing them at billions, regardless of current income. Some have discussed going public. For some, limited pools of employee stock are trading for obscene amounts.

The investor excitement, or concern, centers on several firms. They include the mobile check-in site FourSquare, which grew 3,400 percent in 2010 and whose founder recently said the company hit a valuation of $250 million. The professional social networking site LinkedIn, set for an IPO, trades for about $3 billion. Those companies are not even the ones pulling in really big numbers. Shares in the company Zynga, maker of the popular game Farmville, are trading at sums so high they imply a valuation of $6.2 billion. At Twitter, discussions with potential investors have come up with valuation estimates of $8 billion to $10 billion. And in December, Groupon turned down a $6 billion buyout offer from Google instead raising $950 million from a variety of investors. It is expected to go public, with advisers saying it could be worth $15 billion.

Then there is Facebook. A Goldman Sachs investment deal produced a total valuation of $50 billion. But that astronomical valuation may actually be low: Facebook employees, like Zynga employees, sometimes sell their pieces of the pie to high-net-worth investors. That secondary market at one point put the overall company’s value at $60 billion. That would make the company the 38th most valuable in the United States, sandwiched right between and 3M.

Add up all of those valuations, and your head starts to hurt. These social media firms barely existed five years ago—a time when most of their founders weren’t old enough to buy beer. Now, just six companies operating in the space are worth about $100 billion. No wonder people are talking bubble.

But there is evidence that we might remain in a rational boom period—or, at least, if there is a bubble, it won’t be nearly as painful as the dot-com bust. For one, the boom remains focused, not broad. The intensive investor interest has centered on relatively few firms, all the dominant players in their fields. These companies have millions of users if not solid income streams or high profits. Nobody is offering to throw wads of cash at also-rans—at least not yet.

Second, the party is small, with only an exclusive coterie of venture-capital firms, investment banks, high-net-worth types, and start-ups allowed in. Back during the dot-com bubble, kitchen-table investors bought into practically any company that tacked an E on the beginning of its name—and then lost their shirts. That is not happening now. According to Renaissance Capital, in 2000, the peak of the tech bubble, 237 technology companies held IPOs. In the past 12 months, there have been 49. And many were foreign firms making an entrée into the U.S. market, not start-ups seeking cash.

Indeed, most of the companies mentioned above have not announced plans to go public yet. Many never will. Rather, they are seeking funding from investment professionals. That means that if anyone’s losing money in the coming crash, it is Wall Street types seeking high returns. It is a real consolation: Such investors know they are taking on risk by investing in young start-ups, and if they lose money, it should have little impact on the broader economy.

Third, although many of the valuations seem high, some watchers argue they are justified—and at the very least, they are raising healthy levels of skepticism around the digital water cooler. It is hard to compare valuations for various social media companies, given their different business models. But Twitter’s numbers are setting off the most chatter. The Wall Street Journal says Twitter’s estimated 2011 revenue is $100 million—putting its $10 billion valuation at a 100 times sales, or, in the Journal’s phrasing, “insanity.” (That’s about five or 10 times the multiple other hot social-media companies are getting, for what it’s worth.)

But are all the high valuations unjustified? These companies are growing apace, making valuation even more of an art than a science than usual. And some watchers argue that valuation needs to take in the, well, value of the networks themselves. Twitter, for instance, has revolutionized how people communicate online. Already, more than 10 percent of Internet users in the United States have signed up. We might not know what that’s worth. But it is not so crazy for investors to want to bet it might be worth something.

Finally, people seem worried about a bubble, rather than delighted by a boom—chastened, perhaps, by the not-so-distant memory of and everything after, also concerned about the recent wretched state of the economy and false confidence from the recent uptick in the stock market. When it comes to froth or bubbles, such skepticism is a good sign.

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