Social media stocks: A bubble, or example of our inability to value exponential growth?

It wasn’t long ago that early adopters of social media were ridiculed by their more conservative associates. If a dollar was thrown over every time some worthy chuckled that only twits tweet or how “bookface” would implode, Biznews would now be in the market for some tasty takeovers. These people weren’t just being facetious. We all battle to understand exponential growth. Our species sees growth in linear terms. We are not made to absorb or understand the mushrooming of the Internet, the doubling and re-doubling of the Naspers share price on the back of its Chinese investment in Tencent, or the global surge in social media. To our own cost. As one of the US’s most celebrated thinkers, nuclear physics professor Al Bartlett puts it: “The greatest shortcoming of the human race is our inability to understand the exponential function.” In this piece, regular Biznews.com contributor, Investec portfolio manager Roy Topol, applies his mind to the explosion in prices of social media stocks. Is this a bubble? Or another reflection of how we do not understand exponential growth? – AH  

By Roy Topol*

Pundits around the world have been left scratching their heads while the social media share bubble continues to inflate. Their question is whether this is history repeating itself (as in the tech bubble of the late 1990s) or if it is something quite different. With the incredible share price performance and high valuations of the respective social media companies, combined with some staggeringly large private deals, their concern is understandable.

Let me start off by saying categorically that the current market is not nearly a frenzy of the same magnitude that we witnessed in the late 1990s. In those years, there were websites with no revenue that were raising capital and listing at ridiculous valuations. The PE ratio of the Nasdaq was at 193 times earnings at its March 2000 peak, versus its PE of 30 times currently.

The companies that are in favour nowadays have real business models and very high revenue growth rates. So it’s not fair to say that this is the same story repeating itself (in other words, that there is a risk that the PE could expand quite aggressively from the current 30x multiple – making this bubble much bigger than it currently is).

However, while we are unlikely to see a situation of these companies falling 80% in the space of a few years (as happened in the early 2000s), with valuations as high as they currently are, there is a real risk that these companies fail to continue at the growth rates that would justify their demanding multiples.

The graph below from The Wall Street Journal illustrates the concern about sustainable growth rates, showing how revenue growth for both Facebook and Twitter has been on a downward trend. This does not mean that they have stopped growing; rather the rate of growth has slowed (down below 4% quarterly growth for both companies).