Facebook: Should you invest in social media?

Skip the IPO. There are many other ways to profit from social media's rise.

(Photo: Sarah Lee/eyevine/Redux)

It’s no secret how much Mark Zuckerberg will make from his company’s initial public offering. As the listing date draws closer—it could be as early as April—the Internet is littered with colourful charts and graphs detailing what the Facebook founder will be worth. It’s expected the total will hit somewhere around US$24 billion. About a thousand others will become instant millionaires. But it’s not just Facebook’s insiders who will profit from social media’s soaring popularity. Canadian investors have the chance to participate too.

Facebook’s user base could top a billion by the end of this year. Other networks are also seeing a massive uptake. LinkedIn has 150 million members. Indonesia hit a million members only two months after LinkedIn added support for its official language. These sites aren’t just adding more users; they’re adding revenue, too. According to BIA/Kesley, a Virginia-based media consultancy, social media ad spending will hit US$8.3 billion in 2015, up from $2.1 billion in 2010.

Social networks are here to stay, but now is likely not the time to buy Facebook shares. Ian Ainsworth, senior vice-president and portfolio manager at Mackenzie Financial Corp., says that, while the company could ultimately be a good buy, it’ll likely take some time. With all its IPO hype, he expects the stock to immediately jump to “ridiculous” prices. The same goes for Twitter, which some people expect to hit the markets in 2013. In the meantime, there are other opportunities out there. Telecoms, mobile manufacturers, online game creators, data storage companies and many other businesses will likely see profits and share prices grow thanks to social networking’s rise.

Social media, says Ainsworth, presents a “massive opportunity” for investors. People aren’t just buying into companies; they’re playing the evolution of the Internet. “The web’s almost 20 years old now,” he says. “It’s transitioned from unsearchable web pages to searchable pages to interactive sites, and now you have predictive applications like Facebook.” This is the most disruptive environment in technology that he’s seen since the early 1990s. Social media has accelerated the smartphone market, it’s helping drive tablet sales, it’s slowly killing the PC, and it’s connecting people in new ways and in new places.

“Mobile computing is not about the developed world,” says David Eiswert, a technology portfolio manager at Baltimore-based investment firm T. Rowe Price. “It’s about everyone in the world. Suddenly everyone is connected to these social networks.”

How to best capitalize on social media’s popularity depends on whether you’re a value or a growth investor. Overall, the tech industry is cheap, trading at around 10 times earnings, but the rapidly evolving businesses, such as social networks have high price-to-earning ratios, often four times the sector average or more. The high P/Es are a sign these firms aren’t yet earning much.


“Their models are under-earning today to hopefully over-earn in monopoly-like structures in the future,” says Eiswert. As a growth investor, he’s buying into that future potential and targeting social media platforms. When it comes to these types of companies, people should buy the business that will own its market. He uses LinkedIn, which, he says, is quickly becoming the dominant career-related website, as an example of how to evaluate social media companies. When it eventually destroys its competition, such as job board, it will be able to charge what it wants for ads, premium subscriptions, job postings and whatever else it offers.

“If it plays out this way, the profitability would be incredible,” he says, adding that in this space, there is usually one site that dominates each niche. The only valuation that really matters is future market capitalization. LinkedIn’s market cap is around US$8 billion today, but based on Eiswert’s projections, it will eventually become a much bigger business. That means that the company is actually undervalued, despite its P/E of 1,130. “People underestimate the pace of adoption, which we think can double. They underestimate its global nature and the ways it can monetize,” he says.

This isn’t a foolproof way of choosing a social media business. Zynga, the company behind FarmVille, a popular game played on Facebook, is also popular with investors, climbing 33% since its IPO last December. Though Eiswert owns Zynga shares, he’s not convinced the company has a sustainable business model. “Games are tough to monetize,” he says. “I’m not sure it’s going to create recurring revenue.”

Growth investors will also want to look at data storage companies, such as VMware. Mark Lin, a portfolio manager with CIBC Global Asset Management, thinks these companies will be major beneficiaries of social media’s growth. The more people post pictures, videos and personal information, the more demand there will be for places that store this data. Data storage is a safer play than social media alone, because social networks, individuals and companies are all storing files virtually—or in the “cloud”—rather than on their own hard drives. Still, it’s social media that’s driving this area’s growth. “All these networks thrive off the ability to build large databases of unstructured data,” says Ainsworth. “And it’s piling up at a phenomenal rate.”

Those who want to play the social media space without risking their hide can look to mobile-related companies. They’re typically more mature, slower growing businesses but beneficiaries of all those status updates nonetheless. Everything from telecoms to hardware and semiconductor makers own a piece of the action. Scott Kessler, a senior equity analyst with S&P Capital IQ, says if it weren’t for social media, the wireless sector wouldn’t be as strong as it is today. People expect continuous access to their online friends, and it’s much easier to tote around a phone or tablet than a laptop. Lin points out that mobile computing devices—smartphones and tablets—overtook PCs in unit sales in 2011. Mature companies like Apple and Google, which make phones and social media apps, are good buys, says Lin, but so is AT&T and other telecoms that will benefit from higher data usage.

Though price-to-earnings is a good way to compare the more stable mobile companies, it’s not useful to assess the higher-growth operations. A good guideline throughout the social media space is free cash flow; the more that’s created, the better the business. For a growth company, free cash flow means it can acquire and continue expanding. For a mature business, good cash flow means it can one day pay a dividend if it doesn’t already.

Investors should also aim for the most dominant company, says Eiswert. That means Apple in the smartphone space, Google in the search industry, LinkedIn in the job market and so on. Of course, it’s hard to know if a leading company today will be on top tomorrow—just look at MySpace, the first big social network. So make sure the business has a significant competitive advantage, says Kessler. The company should have multiple revenue sources and a sustainable business model that will keep bringing in cash. Like any high-growth sector, social media’s a risky place to be, but if a company can clearly show how much money it has in the bank, how it’s allocating capital and what its plans are, there will be fewer surprises.


Our picks

LinkedIn Corp. (NYSE: LNKD)
Portfolio manager David Eiswert can’t get enough of this social media platform based in Mountain View, Calif. The career networking site has multiple revenue sources and is quickly overtaking other job boards as the place to be for professionals. He thinks its nearly US$9-billion market cap is too low, and with rapid emerging-market growth it will easily double its user base.

With a price-to-earnings ratio of 24, EMC Corp., based in Hopkinton, Mass., is one of the cheaper data storage companies on the market. It owns the cloud infrastructure company VMware, which many analysts say could be one of social media’s big winners, and it offers data analysis, security and management services too. The more personal data that piles up, the more demand there will be for companies like EMC, says fund manager Ian Ainsworth.

Apple Inc. (NYSE: APPL)
If you want to buy a more mature business, consider Apple, based in Cupertino, Calif., which is trading at around 14 times earnings. It’s raking in the cash—“It could buy McDonald’s out of its cash flow,” says Ainsworth—and its products are dominating the mobile industry. As more people crave the immediacy of social media, more of its phones, and especially its tablets, will fly off the shelves. Ainsworth thinks that, with all that cash on hand, it will soon start paying a dividend.

Google Inc. (NASDAQ: GOOG)
It’s hard to imagine this company getting any bigger, but portfolio manager Mark Lin says social media is presenting great opportunities for Google. The more people search the web for Twitter profiles and Facebook pages, the more it will make off its ads. Plus, it’s got its own social networks in Google+ and YouTube. It’s also a major player in the mobile space—its Android operating system is the most widely used operating system on the planet, and it bought phone maker Motorola last August.

Jive Software (NASDAQ: JIVE)
This social network for companies, based in Palo Alto, Calif., resembles Facebook but has business applications that make it a great collaboration tool. Users can create threads around a specific topic and post photos, videos, comments and more. It only went public in December, but Eiswert thinks its US$1-billion capitalization is too low. As more people work remotely and look for better ways to communicate, this company should take off, he says.