Why Social Media Is Overhyped as an Engine of Growth

It doesn't seem like much of an exaggeration to say that investing and media circles are gaga over social media companies such as Twitter and Facebook. But it isn't just their demonstrably significant cultural and media impacts that are creating a buzz. It is the prospect that they will generate a new wave of growth and wealth, much as Web 1.0 companies did in the late 1990s.

For example, DailyFinance recently reported on claims by some analysts that Facebook could be worth $100 billion by 2015 -- fully half of Apple's (AAPL) $200 billion market cap.

These future valuations are based on revenues from advertising and virtual games -- and extrapolations of the value of each of the estimated 470 million Facebook users. According to the widely read blog Inside Facebook, revenues in 2009 were in the range of $635 million.

Apple's Market Cap Hits $200 Billion

The basic idea is that Facebook revenues could soon top $2 billion a year, and with a forward price-earnings ratio of 50, that equals $100 billion in market value. Except, oops, that $2 billion is revenue, not earnings.

Just for comparison's sake, Apple's first quarter 2010 revenues were $15.68 billion, generating $3.38 billion in net profit. Based on the expectations of $10-plus billion in net profits annually, Apple's market cap recently hit $200 billion.

Facebook currently has about 1,200 employees and other overhead expenses. While the actual net on its estimated $635 million revenues is unknown as it remains a privately held company, any company generating gross margins of 50% or more is doing quite well. So let's suppose Facebook reaps $325 million in gross profit and pays corporate taxes (up to 35% in the U.S.) on that profit, yielding around $225 million in net profit.

Social Media Is Dependent on Ads

If we apply the same multiple that investors give red-hot Apple (around 20 times anticipated annual net profits), then Facebook's market cap would come in around $4 to $5 billion -- a far cry from $100 billion.

Double the revenues and net profit and you get $10 billion. Even $1 billion or even $2 billion in revenues is not a lot of money when you're bandying around numbers like $100 billion, and it is a far cry from Apple's projected annual revenues of $50 billion and net profits of $10 billion.

The other problem with these valuations of social media sites is that they are all drawing upon the same revenue source: Advertising. And after skyrocketing from $2 billion in 2003 to over $23 billion in 2008, online advertising revenues actually fell in the first half of 2009, according to the Interactive Advertising Bureau (IAB). Total Internet advertising revenues were $10.9 billion in first half of 2009, falling 5.3% when compared to 2008's first half.

Online Ads Are Still a Small Pie

Just for comparison's sake, newspaper ad revenues were about $28 billion in 2009. Though down from their peak of $49 billion in 2005, this is still significantly larger than total online advertising.

The point is that despite its rapid growth, Internet advertising is still a small pie of revenues for millions of sites to be sharing.

To use Apple as a reference point again: $23 billion is about half of Apple's expected 2010 revenues. And Apple is just one company among hundreds of global giants. In a $13 trillion economy, $25 billion just isn't a lot of money.

The entire advertising market for all media in the U.S. -- TV, cable, radio, print and Internet -- was $235 billion in 2009. Approximately $130 billion was spent on local ad buys and $105.4 billion on national advertising.

The Real Value of Virtual Games

So online advertising took about 10% of the entire advertising pie. Even if the online ad market resumes its growth, analysts are looking at a total market of $37 billion by 2013 -- still small change compared to total advertising and to the U.S. economy.

Many observers are enthused by the rapid growth of virtual games in which participants spend real money to buy virtual objects in the game. At least one analyst quoted by BusinessWeek believes virtual games could add $175 million a year to Facebook's revenues.

Perhaps, but Facebook's virtual gaming revenues in 2009 were estimated at a more modest $10 million.

Social Media's Modest Financial Impact

Even the most enthusiastic estimates of Facebook's future revenues -- $2 billion in advertising (7.5% of all online advertising) and $175 million in virtual gaming -- still don't get close to Apple's expected $50 billion revenue and $10 billion in net profit.

While the popularity of Facebook, Twitter and other social media sites is unquestioned, to assess their financial impact on the $13 trillion U.S. economy we need to place the speculative enthusiasm within a broader context.

According to recent reports, Twitter has 156 employees. Add in Facebook's 1,200 employees, and you're up to 1,356. In an economy with 135 million jobs, that's a very small number. Yes, social media is having a major effect on communication and media globally, but its financial impact is rather more modest.