MercoPress. South Atlantic News Agency

The bursting of the social media bubble: Dot-com déjà vu?

Between March 2000 and October 2002 the dot-com crash wiped out 5 trillion dollars in the market valuations of technology companies

By Ned Raynolds - A joke currently making the rounds on Wall Street has it that a bar opened in Silicon Valley, giving away drinks for free. The place was soon wall-to-wall with people. Other West Coast saloons latched onto the idea, figuring that a business model that attracted so many patrons couldn’t fail.

Behind the joke is the wave of investor euphoria that accompanied the recent advent of the social media companies. And before it, and forgotten by many, the rise and fall of the dot-com stocks. In both cases, the market’s excitement was based not on a realistic estimate of financial prospects, but simply on the large numbers of followers these companies were able to amass.

It was little more than a decade ago, from 1995 to 2002, when dot-com stocks soared into the stratosphere, only to crash to earth with the proverbial “dead cat bounce.” Dot-com evangelists were writing books like “New Rules for the New Economy,” proclaiming the old laws of economics dead, replaced by a new model of creating huge online networks and giving stuff away for free, like the apocryphal Silicon Valley bar.

Eight-figure salaries were being scored by stock analysts like Morgan Stanley's Mary Meeker, who were selling the notion that “companies without earnings could transform the world and climb to the moon“as Fortune reported in 2001.

Then one day the stock market woke up and asked, “How are these companies going to monetize their networks?” For many dot-coms there was no clear answer. Between March 2000 and October 2002 the dot-com crash wiped out 5 trillion dollars in the market valuations of technology companies.

Fast-forward to the social media era. As Facebook prepared for its initial public offering (IPO) on May 18, it reported 900 million users worldwide. Facebook CEO Mark Zuckerberg was hailed as a young genius and who could dispute that he was, given that he built up his huge Facebook following from an online student network he launched from his dormitory room at Harvard?

Excitement built for the Facebook IPO. Morgan Stanley, the lead underwriter, set the offering price at 38 dollars a share, valuing the company at 104 billion. But when trading opened, the stock sold off almost immediately.

No doubt, that was in part due to the fact that General Motors pulled its Facebook ads a few days before the IPO, finding that Facebook click-through performance trailed that of other online providers, such as Google's AdSense.

So, could Facebook give investors evidence that it was effective in stimulating sales for its advertisers? CEO Zuckerberg wasn’t able to come up with an answer that soothed his new shareholders and the stock continued to slide.

But warning signals were out there for those who cared to take note. More than three months before the Facebook IPO, on February 13, Bob Rice, managing partner at Tangent Capital, questioned Facebook actual user base on a Bloomberg News broadcast.

“Facebook is counting anybody who says they like Facebook as an active user,” Rice said “but there is no way to monetize that action. What is the active user base? What is the growth rate?”

That troubling concern about monetizing that sunk the dot-coms was back.

Other social media companies’ stocks have plummeted from their initial offering prices as well. By mid-August, shares of Zynga, the Internet video game firm, had plunged by 69%, and the stock of online deals company Groupon had fallen by 72%. Facebook stock at this writing traded around 20 dollars, down 47% from its 38 offering price, as investors have carefully re-evaluated its prospects.

Does that mean social media companies are just a blip in business history? The dot-coms certainly weren’t. Look at how many of them are thriving today. The list includes not only the giants like Google, Yahoo and Amazon, but a raft of others, including Priceline.com, Stamps.com and Web.MD.

Among social media standouts is LinkedIn, whose business model is tied to executive searches and hiring and thus racks up a healthy revenue stream from premium services like those it sells to headhunters.

As this was written, LinkedIn was trading around 114 dollars, about two-and-a-half times its offering price of 45 dollars on May 19, 2012. Another is Foursquare, a mobile-focused tool “for finding friends, navigating the city and rewarding oneself for discovering bars + restaurants + good times.”

Foursquare’s partnership with American Express and its recent focus on revenue generation have gotten the attention of some savvy investors who are waiting for its expected IPO.

Like all of us, ‘Wall Streeters’ can get giddy over glamorous new ideas. So, when a sexy new businesses concept comes along, it may take some time for the market to wise up and award values based on reasonable expectations of future earnings. Investors therefore might be well-advised to avoid getting caught up in the euphoria that accompanies the debuts of these companies’ stocks and to wait until reasonable valuations are established.

(*) Ned Raynolds is an investor relations and corporate communications specialist who avidly follows the investing and economics worlds. He has advised hundreds of public companies about best practices in communicating with investors, and he has produced scores of investor surveys and reports. Ned has written on investing subjects for publications, such as The Wall Street Journal and Directorship.