The True Value Of An Idea: Why These Social Media Stocks Are Likely Overvalued

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By Robert Palumbo :

Ideas are a wonderful thing. They are the driving force behind all things creative and different. They fuel businesses, provide an endless source of jobs and create value. But what is the intrinsic value of an idea? In any business, an idea is ultimately worth the value of the earnings generated through its execution.

As many witnessed in the dot-com bubble of 1995-2000, the market often places excessive value on ideas which fail to generate meaningful earnings. For a short time, hype and speculation rule the day. But this doesn't last forever. History may be repeating itself when looking at the current valuations of social media companies. I recently came across an interesting excerpt by entrepreneur Derek Sivers that I thought was relevant and worthy of a share (note: it's a bit dated as it's from 2005):

It's so funny when I hear people being so protective of ideas.

To me, ideas are worth nothing unless executed. They are just a multiplier. Execution is worth millions.

Explanation:

AWFUL IDEA = -1 NO EXECUTION = $1
WEAK IDEA = 1 WEAK EXECUTION = $1000
SO-SO IDEA = 5 SO-SO- EXECUTION = $10,000
GOOD IDEA = 10 GOOD EXECUTION = $100,000
GREAT IDEA = 15 GREAT EXECUTION = $1,000,000
BRILLIANT IDEA = 20 BRILLIANT EXECUTION = $10,000,000

To make a business, you need to multiply the two.

The most brilliant idea, with no execution, is worth $20.
The most brilliant idea takes great execution to be worth $20,000,000.

That's why I don't want to hear people's ideas.
I'm not interested until I see their execution.

What Sivers is getting at is that many don't recognize that ideas without a solid record of execution are of little value. The amount of time required to come up with an idea pales in comparison to the time and work required to continuously execute on one in a competitive market. Investing in cool ideas for the sake of novelty appears to be a good way to get burned. Ask investors in 2000′s oft-maligned Pets.com, which fell from a stock price of over $11 to $0.19 in a span of just 9 months. Possibilities are always 'endless' at the outset of an idea. The question is whether or not the people behind the idea are worth investing in and whether they will be able to execute at a level that justifies the valuation.

Publicly traded social media companies such as Pandora ( P ), LinkedIn ( LNKD ), Yelp ( YELP ), Zynga ( ZNGA ), Facebook ( FB ) and Groupon (GRPN) may have great ideas behind them, but execution and effective monetization is what counts. I believe the market is overestimating the ability of these companies to rapidly grow earnings in a sustainable fashion. I am not saying that social media is a fad or that online companies cannot be great businesses. I am not even saying that these companies do not have solid business plans. What I am saying is that until these companies start generating real earnings, investing in them at their current valuations is simply gambling.

LinkedIn, which may be one of the better companies of the bunch, trades at a ridiculous 912 times earnings. Even after its recent hammering, Facebook trades at 115 times earnings. The rest of the above companies do not even have earnings to speak of. They are all priced with an assumption of perfect execution of their business plans and pie-in-the-sky growth projections. There are many risks and challenges ahead. If that brilliant execution does not materialize, share prices are going to drop. As a great strategist once said, "no plan survives first contact with the enemy". Continual execution amidst a changing environment is vital.

The truth of the technology sector is that competition is fierce and economic moats are much frailer. You may be the first to get your idea to market, but if somebody can execute that idea better you will lose your edge very quickly. The success story of Apple (AAPL) can be told in the execution of great ideas that already existed. Microsoft (MSFT) attempted to introduce the mass-market Tablet PC many years ago. How many consumers actually bought one? Our knowledge of today's market tells us that the consumer tablet was a great idea. But Microsoft had weak execution. Apple's introduction of the iPad disrupted the industry and showed that brilliant execution is what is paramount. Similarly, there were many MP3 players on the market when the iPod was first released. Apple simply executed the idea of having digital music in your pocket in a much more effective and user-friendly way. Ideas are secondary to execution when talking about value creation.

All of the above social media companies are at risk of having somebody else executing their idea in a more compelling and user-friendly way because the barriers to entry are relatively small. By valuing these companies at billions of dollars with weak or no earnings, the market is assuming that they are infallible and that the earnings will definitely come. That assumption implies brilliant execution amidst a constantly changing competitive environment.

Yet, consumer usage of online services is fickle and every web-based company is susceptible to the 'fad' effect. The drop in usage of once-popular services such as MySpace, AOL, Ask Jeeves, Friendster or most of the dot-com bubble companies attests to that. Competitive factors aside, the trends in digital consumption towards increased mobile usage relative to desktop paired with a general slowdown in the global economy will hurt optimistic growth assumptions. It is not wise to invest based on the quality or uniqueness of an idea alone. Execution (i.e. sustainable earnings) are what will count in the long run.

Indeed, I am sure that there will be many investors that will generate healthy returns gambling on some of these companies. Many more are going to get burned. It will be a challenge for social media companies to execute to the level of the lofty expectations inherent in current valuations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

See also 7 Profit-Heavy Large Caps Keeping Down The Debt on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Technology

Referenced Stocks: FB , LNKD , P , YELP , ZNGA

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