Why Facebook and Twitter May Not Be Overvalued

It’s easy to write off social media stocks and their ludicrous valuations. Take Facebook (FB), which reports third-quarter earnings Tuesday. The stock is already up 42% in 2014, and 267% over the past two years. With a market cap of over $200 billion, investors value the company more than Ford (F), Boeing (BA), and Starbucks (SBUX) — combined. (All data is as of market close on Oct. 21.)

It’s something to scoff at: Those companies make things. Real things. Facebook is… just a website, really. Unplug your router or turn off your smartphone, and it ceases to even exist. How can a service so enigmatic and fragile be worth almost four times more than the maker of America’s best-selling pickup truck?

Here’s the thing: Facebook has entrenched itself in the lives of hundreds of millions of people. It’s no longer something most users even think about — it’s just a given, something that’s always there, like the sun, or Google, or the nightly news anchor back when there were only three TV channels. And that’s some pretty powerful company.

When the Tail Wags the Dog

Or consider Twitter (TWTR). Watch any prime time TV show or ESPN sportscast and you’ll see a hashtag or Twitter handle on the screen that the social media company didn’t even pay for.

During the 2014 Academy Awards, Samsung reportedly paid $5 million for host Ellen DeGeneres to display the company’s new smartphone on air. And what did Ellen do with it? She made a big fuss about taking the most retweeted photo of all time — and Twitter didn’t have to pay a dime.

It reminds me of an old Jerry Seinfeld joke about aliens looking down at dogs and their owners on Earth: “Dogs are the leaders of this planet. If you see two life forms, one is making a poop, the other one’s carrying it for him, who would you assume is in charge?”

As overpriced as their shares seem, Twitter and Facebook may be far more powerful — and valuable — than we realize.

Cultural Clout

These companies are not just household names, they’re dictionary entries. Like Kleenex, Legos, Xerox, and Google, their influence is so pervasive that their trademarked terms have entered common usage as nouns or verbs.

Facebook is a verb in the Oxford English Dictionary. Unfriend was added as a verb in 2009. Tweet, Twitterati, hashtag — they’re are all in there, too.

Again, this places Facebook and Twitter among some powerful company. If you had invested in Google (GOOG) back when it first appeared as a verb in 2006, you’d be sitting on gains upward of 150% right now.

But What About the Profits?

Critics argue that tech investors pay too much attention to user growth and not enough attention to profits. But what tech startups are doing — sacrificing short-term profits to grow, grow, grow — is hardly a new approach to building value.

It’s no different from an intern who busts his butt for free all summer in hopes of getting signed to a full-time job, or a young baseball player approaching a contract year, trying to put up great numbers so he can negotiate a big payday when the time comes. In a way, it’s as old as the American Dream: Prove yourself first, then cash in.

And Facebook has learned how to cash in — indeed, it’s been setting the standard for other social media companies. With ads now better integrated into users’ news feeds, especially on mobile devices, revenues and earnings have soared. Analysts expect Facebook earnings to grow 85% this year and 25% next year — simply astounding numbers when the U.S. economy is lurching along at a 3% clip.

There’s a decent chance that Facebook could become this decade’s Apple (AAPL) — after all, like Apple, it introduced a whole new product category and then went on to dominate it. Sure, the stock’s forward price-to-earnings (P/E) ratio — a useful, but not end-all-be-all, guide to valuing stocks — is high, at 39. But it’s not Netflix (NFLX) high (75), or Amazon.com (AMZN) high (165).

Or Twitter high (137).

Twitter, which reports earnings Monday, has had a more difficult year. In its last quarterly earnings report, investors were disappointed as user growth stopped accelerating as quickly. The stock is actually down 20% year to date — the remnants of a dramatic sell-off in the first part of the year — though shares have recovered steadily, gaining 59% since early May.

‘Not Overvalued’ Doesn’t Mean ‘Undervalued’

Still, would I buy Facebook or Twitter at these prices? Do I think either company is really more valuable — even just potentially more valuable — than, say, Disney (DIS)?

Probably not, and no. Facebook has infiltrated my life, and quitting it would leave me restless and twitchy… for a while. But I’d get over it. I could live — probably quite happily — in a world without Facebook. I enjoy Twitter, but when I forget to check it for a few days in a row, I don’t miss it.

However, I can’t imagine spending the rest of my life, or my daughter’s, in a world without “Frozen” and “Toy Story,” or ESPN, or the original “Star Wars” trilogy. (Although I’m able to imagine life without the three prequels just fine, thanks.)

Despite Facebook’s widespread usefulness and its massive reach into every corner of the earth, it has yet to sink its hooks into people’s treasured experiences. It connects people, sure — but most people don’t feel all that connected to Facebook.

That may change in the coming years if the social network continues to grow more ingrained in people’s behavior and as a fixture in their best memories — although memory-making teens don’t use it as much as you’d expect. By the time it reaches that point, though, it will probably be too late to scoop up Facebook shares “on the cheap.” That’s the rub when you’re investing in tech: Early investors take the biggest risks, and either reap the biggest rewards — or lose the most.

Is There Such a Thing as Safe Tech?

Technology is an exciting, high-growth sector — and, as we witnessed during the dot-com crash, even its brightest stars can come crashing down quickly. So even if Facebook and Twitter aren’t as overvalued as some people think, when it comes to tech investing, I still tend to prefer more diversified companies such as Google or Apple.

For all its cutting-edge projects, Google is still primarily an advertising company — the leading one in the single most dominant medium of the new century. Its search ad revenue growth slowed last quarter — from 21% down to 17% — and there is evidence that Facebook is actually beginning to steal ad market share from the search engine (another reason Facebook may not be overvalued).

But Google still controls about a third of the $120 billion Internet ad market and 44.6% of all mobile advertising, according to eMarketer estimates. Imagine a company 100 years ago that controlled a third of all the world’s newspaper ads!

That cash cow allows Google to keep investing in new technologies, from driverless cars to wearable tech. Many of these initiatives will surely flop, but others could become the next Android operating system — perhaps Google’s biggest hit outside of search.

Apple, similarly, has plenty of irons in the fire. For starters, it still makes things, from top-rated computers to the world’s single most popular smartphone. Tablet sales have slowed, but that’s not going to sink a company that will sell 60 million iPhones, one of the highest-margin products in the world, this year.

Meanwhile, Apple expects its iTunes platform to haul in $4.6 billion in revenue this year, driven by the App Store. It pretty much failed at social networking, but it could be the company that finally brings mobile payments mainstream. That’s a big, big prize.

Like Google, Apple has a comfortable cash cushion that allows it to innovate constantly and take its time getting products right before launch.

One Last Thought

If you like the trajectory of technology as a whole, but are uncomfortable buying Facebook or Twitter at these prices, or even going all in on a single, more established company such as Google or Apple, then perhaps the answer is to diversify.

An easy way for average investors to gain broad exposure to technology stocks is through a low-cost exchange-traded fund (ETF), like the PowerShares QQQ Trust (QQQ). This ETF cheaply tracks the Nasdaq Composite index and offers weighted exposure to all facets of the industry, from smartphones to semiconductors to social networking.

The fund’s top holdings include industry stalwarts Apple, Google, and Microsoft (MSFT), fast growers Facebook and Amazon, big biotech Gilead Sciences (GLD), and chipmakers Intel (INTC) and Qualcomm (QCOM). There may not be much safety in tech, but at least there is some safety in numbers.

At the time of this writing, the author held shares of QQQ and AAPL.

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