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Will bubble burst for Twitter, Facebook?

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Posted at 9:16 PM, Oct 27, 2014
and last updated 2014-10-28 08:09:54-04

Facebook, Twitter and LinkedIn have become staples for the social media experience, but they remain in relative infancy compared to other publicly traded companies.

That has not stopped the companies from drawing in huge dollars from Wall Street investors.

Facebook has a market value of $200 billion — larger than Bank of America, PepsiCo and Comcast. Facebook is set to release its quarterly corporate earnings after the market closes Tuesday.

Valued between $25 and $35 billion, Twitter and LinkedIn are not tiny companies either.

But how did they get so big and can they last?

Cordell Professor of Finance at the University Florida Jay Ritter, an initial public offering expert, said the top social media companies have learned lessons from the tech companies whose bubbles burst in the late 1990s and early 2000s.

“Many very young internet companies with only a business plan and without any revenue went public,” he said. “Ever since the tech bubble burst in 2000, very few young tech companies have gone public.”

Facebook started publicly trading shares in May, 2012 at $38 per share but now shares go for more than double that amount. Twitter and LinkedIn are also trading higher than their initial public offerings.

All three companies are impacted by network externalities, which means the services provided by a company have more value when more people use it, Ritter said.

One person drinking a beverage does not impact another person’s experience with the same beverage in the way that a social media network of one is vastly lonelier when compared to a social media network with a billion users.

“One of the features of network externalities is competition doesn’t necessarily push profits toward competitive levels whereas with something like restaurants or steel companies, competition between firms makes it very difficult for one restaurant chain to earn abnormally high profits,” Ritter said.

Ritter said when he evaluates social media companies, he wants to know whether the company is a winner. 

“Back in the internet bubble, there might have been eight companies going public all fighting to be the winner, and it turned out some of the niches, zero out of eight companies succeeded because not all of the niches turned out to be profitable,” he said.

But LinkedIn, Twitter and Facebook only went public after creating a dominant market share. Still, Wall Street investors have had a difficult time determining the proper valuation for social media companies.

Facebook started at $100 billion, dropped to $50 billion and rose back up to $200 billion in market share.

“All along people have largely bought into the notion that Facebook has a franchise that is somewhat impervious to competition, but just how profitable that will be still is a question mark,” Ritter said.

Traditional historical accounting information also is not as useful in figuring out future success when compared to other staple industries. Social media companies are more like bio-tech companies in that past research and development spending don’t always correlate to profits down the road. Twitter, for example, met Wall Street's earnings expectations after the market closed Monday, but the company's stock was rocked after investors wanted more signs of future growth.  

But having established profits and market share is still a key. Not all social media companies have seen success on Wall Street. Groupon and Zynga are two companies that trade far below their initial public offerings.

“With Groupon, it never did achieve Facebook-like valuations and unlike Facebook, it was not profitable at the time of going public,” Ritter said.