Why I Like Facebook and These 6 Other New-Media Stocks

On May 17, 2012, Facebook (FB) raised $16 billion in one of the largest and messiest initial public offerings of all time. The shares, which originally sold for $38 each, fell within a few weeks to $26 and by September to $18. On news of strong revenue gains, Facebook soared to $72 in early March, then started to drop again. The question for current shareholders is whether to hang on -- and for noninvestors, whether to take the plunge.

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Facebook isn't the only new-media tech stock that had been soaring until a vicious correction began in March. The same holds for shares of other companies whose livelihood is linked to the Internet. Twitter (TWTR) has nearly doubled in the five months since its IPO raised about $2 billion. Shares of TripAdvisor (TRIP), the world's largest online travel company, have jumped from $30 on October 31, 2012, to $86 today. Among large online businesses, Amazon.com (AMZN) has quintupled over the past five years, and Netflix (NFLX) has quintupled in just a year and a half. (Prices and returns are as of April 4; stocks in boldface are those I recommend.)

The problem with assessing such stocks is that the usual valuation standards don't apply. Twitter and Yelp have never made money. Amazon's price-earnings ratio, based on projected 2014 profits, is 167. The forward P/E for LinkedIn is 105; for Trip­Advisor, 40; for Facebook, 45; and for Netflix, 83. The P/E for Standard & Poor's 500-stock index is just 16.

Many Internet companies are growing so fast that measures of value, such as P/Es, are meaningless, and it's nearly impossible to predict earnings for a fledgling high-tech company. Still, we can guess.

Let's do the math for Facebook. The consensus of experts is that earnings will roughly double in 2014, to $3.3 billion, or $1.26 per share, on $11.4 billion in revenues. That's serious money. Let's assume that earnings growth will slow to a more sustainable 30% annually for the next five years. In 2019, then, Facebook's profits would be $4.68 per share. The stock currently trades at $57. Let's say that, as an investor, you would be happy to see Facebook double in value in five years. By 2019, the price would be $114, or 24 times that year's earnings. That sounds reasonable.

Of course, no one has the foggiest idea whether Facebook's profits will really grow 30% a year. The same holds for projections of earnings growth at somewhat more-established Internet companies, such as Amazon and Netflix. But the history of Google (GOOG) may be instructive. The stock went public in August 2004 at $85 per share. The company earned $5.20 per share in 2005 and $36.05 in 2013. That's an annual compounded growth rate of about 28%. So assuming Facebook grows as fast as Google did, investors should feel comfortable buying at current prices. But this analysis, with all its assumptions, tells you only that Facebook does not appear wildly overpriced. There are other, relatively subjective questions you need to answer before you invest in a fast-growing Internet company.

Is the business based on a good idea? This is crucial. Mark Zuckerberg created the social network, an online web of interests and information that binds friends, relatives and like-minded folks across thousands of miles. He built his brand quickly and powerfully. The only obstacle was figuring out how the company would make money. But Zuckerberg found the solution: sell advertising. Facebook's revenues have risen from $2 billion in 2010 to $8 billion in 2013, and they are expected to approach $15 billion in 2015. Facebook's latest breakthrough has been its ability to sell a growing number of ads on mobile devices.

Do you trust the leadership? So far, so good: Zuckerberg and his crew haven't made any major mistakes -- with the stock up, the disastrous IPO is forgiven -- and they are showing more appetite for experimentation than, say, Microsoft. So far this year, Facebook has announced it intends to purchase WhatsApp, a mobile-messaging application, for $19 billion and Oculus, a maker of virtual-reality headgear for gamers, for $2 billion. Investors have reacted to these incredibly expensive deals with skepticism. Facebook's stock dropped by nearly 20% in three weeks in March. The $21 billion for the two purchases represents more than one-eighth of Facebook's market capita­lization (shares times price), and you might conclude that Facebook's leadership is getting bored with running only Facebook -- or maybe worried about the growth prospects of a business that already has 1.2 billion monthly active users. But I am more sanguine. Building an Internet business requires taking risks, and buying other companies to get not just patents and products but also talent and ideas for future growth seems worth the risk.

Does the company have a significant edge on the competition? There's evidence that Facebook is losing some of its cool factor among younger users. Twitter is still far behind Facebook in users, but it is a serious competitor. For online advertising in general, the main competitor is Google, whose revenues are about seven times greater than Facebook's, even though its market cap is only about two and a half times larger. Facebook's main global competitor is China's Tencent Holdings (TCEHY) and its mobile-messaging app WeChat. The field is clearly becoming more crowded, but Facebook's brand remains strong.

Does the company have room to grow? All of the online social-networking and information-services firms are only scratching the surface. As users get more used to trading some of their privacy for such benefits as being offered goods and services geared directly to them, the Internet advertising market could explode. The potential is huge.

Facebook is not the only Internet business that receives positive answers to all four questions. I particularly like Twitter, with more than 240 million monthly users. It is young and risky, as evidenced by the range of 2014 earnings estimates by 30 analysts -- from a gain of 16 cents per share to a loss of 19 cents. Twitter has about one-sixth the market cap of Facebook, which means it's got room to run. I'm also fond of TripAdvisor, which is breaking out of the travel pack, and Open­Table (OPEN), the innovative online restaurant-reservation service. I continue to be a fan of Amazon, which, like Twitter, took a hit after earnings did not meet expectations. The shares have sunk about 15%, presenting a buying opportunity. And no serious stock portfolio is complete without Google and Netflix.

If you prefer an exchange-traded fund, you'll be well served by First Trust Dow Jones Internet Index (FDN), which charges annual expenses of 0.60%. Top holdings are Amazon, at 7.2% of assets; Facebook, 6.2%; eBay (EBAY), 5.8%; Priceline.com (PCLN), 5.6%; and Google, 5.0%. Also top-notch is PowerShares Nasdaq Internet (PNQI), with the same expense ratio, the same five biggest stocks and similar returns.

Sure, you should have bought all these Internet stocks a few years ago. But I'm convinced it's the dawn of a new technology era. Well, maybe it's 10:30 a.m., but it's certainly far from sunset.

James K. Glassman is a visiting fellow at the American Enterprise Institute, where he is affiliated with the new Center for Internet, Communications and Technology Policy. He owns none of the stocks mentioned.