How Retail Investors Should Evaluate Social Media

Facebook’s decline provides a roadmap to seek true value.

Business school applicants who think they can Tweet their way into an MBA program may be in for a surprise.

Back in May, Facebook offered shares of its stock for $38 in its initial public offering (IPO), confident that the sheer number of Facebook users—all 800 million of them—would be enough to power the stock higher.

After three months on the market, it's clear that Facebook and the bankers who were backing it were very wrong.

[See The Rocket Science of IPOs: Hype Is Not Fuel, It's Baggage.]

Facebook stock is currently trading below $20 a share, and there are fears that the stock could go even lower. Its steep drop also makes Facebook the second-worst performer since January 2011. The first? Another social media company, game maker Zynga.

The failures of Facebook and Zynga are reminiscent of technology companies that failed when the dot-com bubble burst more than a decade ago. Both IPOs were surrounded by hype and an underlying belief that they provided a chance to make a lot of money in a short period of time. But once on the market, it became clear that these companies were overvalued, and the price of their stock fell quickly.

It's not just large institutional investors who have been hurt by Facebook's sharp decline. According to reports just after the IPO, mom-and-pop investors lost $630 million in the days following the initial sale. If these investors still hold the stock, they have lost even more.

Wall Street is now split on whether Facebook will be a success. In June, after assessing the company a month after the IPO, a majority of analysts at major investment houses ranked the stock a "hold" rather than a "buy." The period in which Facebook employees were prohibited to sell stock is coming to an end, so many could cash out, flooding the market with shares. Until Facebook can prove it can generate consistent revenue, these ratings are unlikely to change. 

The Facebook IPO is likely to serve as a warning to other social media companies considering going public. It should also serve as a warning to retail investors, who need to be wary of buying into the hype around social media.

"The act of taking companies like this public is now tainted. That process is under some scrutiny," says Nick Westergaard, founder of Brand Driven Social, a marketing firm that helps companies maximize their online brand.

[See Should I Care If My Mutual Fund Owns Facebook?]

What went wrong? Facebook's initial decline was due to a number of factors, including trading glitches that played a part in spooking investors into a sell-off. But the stock's continued downfall is due primarily to the fact that the company has yet to prove it can make money. Right now, its only real value is in the number of people who use it. Until these users can use Facebook in a way that makes the company money over the long term, it will struggle.

According to Westergaard, a company like Google makes money because it has a pay-per-click advertising model. Facebook employs something similar, but it has yet to generate revenues that justified its initial high stock price.

Then there's the question of the company's future. Facebook transformed the way people exchange information. But technology changes quickly, and social media is evolving. There is no guarantee people will use Facebook a decade from now.

Westergaard also says Facebook's leadership did a poor job of outlining long-term goals. "It's up to Facebook's leadership to define the company. I don't think they've been very effective on that," he says.

[See Lessons From the Facebook IPO.]

Lessons for retail investors. It's unlikely that many other social media companies will go public in the short term, given how spooked Wall Street and the public are over Facebook. But inevitably down the line, excitement will build, investors will line up, and a social media company will have an IPO. Should retail investors buy the hype?

The Facebook IPO offers concrete lessons for investors. First, look at the leadership of the company. Are they prepared to be transparent? Do they understand how to manage a publicly traded company?