A recent investment by investment banking firm Goldman Sachs valued Facebook at $50 billion. The company was only founded in 2004, meaning the valuation went from zero to the stratosphere in just six years.

A number of other leading social media firms are also being valued in the billions. These include firms such as Twitter, LinkedIn, Zynga and Groupon, the last of which was rumored to be offered $6 billion from Google to fold it into its market-leading online advertising business. Each of these firms is less than 10 years old, so while the rapid increase in values has been impressive and has made early investors rich, signs are emerging that investing in social media is reaching bubble proportions. (To learn more, see 5 Ways To Spot The Next Bubble - And Avoid It.)

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  1. Unproven Business Models
    The social media firms have undoubtedly seen success in building a vast community of committed users. Facebook boasts more than 500 million users while Twitter has nearly 200 million "tweeters" and LinkedIn has more than 80 million job professionals using its site for networking. Groupon has about 35 million people signed up to receive a deal-of-the-day email and online gaming site Zynga has millions of committed gamers playing its games.

    In general, though, most social media firms are still trying to figure out how to capitalize on their vast user bases. LinkedIn has seen success by charging users for the ability to see, sort, and search for additional information on other users while Groupon gets a cut of each deal that its users buy, but Facebook, Twitter, Zynga and other sites rely on advertising that is more difficult to properly customize on their sites. In the "Social Network" movie, Facebook was said to be wary of killing its cult status early in its development by plastering its sites with advertisements and users on many of these sites could be turned off if the ads become too aggressive or intrusive. (For more, see 5 Private Companies Worth Billions.)

  2. Barriers to Entry Concerns
    It may seem like ages ago given how fast things move in cyberspace, but firms including AOL (NYSE:AOL) and MySpace were at one point internet darlings that were supposed to take over the virtual world. AOL was so richly valued at one point that it was able to use its overvalued stock as a currency to snap up old-media rival Time Warner back in 2000. Just a couple of years later, the newly formed company started writing down the value of AOL and the deterioration in value continued until Time Warner spun off AOL to shareholders in late 2009. AOL now has a market capitalization of under $3 billion or a mere fraction of its value at the apex of its hype.

    An even closer comparison in more recent times surrounds News Corps (Nasdaq:NWSA) purchase of MySpace, a social networking site where, according to an article at the time of the acquisition, "users connect to the site for dating, making friends, professional networking and sharing interests."

    The purchase price was for just under $600 million, which is peanuts in today's market of billion-dollar valuations. However, News Corp has already written down the value of MySpace (a division of News Corp's Fox Interactive Media division) and is cutting staff as advertising has failed to take off and the site has lost ground to Facebook and newer rivals.

    These are just two examples of how online firms can succumb to competitive pressures and suggest investors need to be more careful so as to not get carried away for enthusiasm for business models in cyberspace as they can easily be replaced by new technologies and rivals. (To learn more, see The Biggest Merger And Acquisition Disasters.)

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  1. Lack of Business Fundamentals
    Little is actually known about the sales and profits of social networking companies. Press releases and discussions in the news speculate as to sales levels. Facebook is estimated to have a couple of billion dollars in annual revenue by now and is said to be profitable while Groupon is said to be seeing sales of $1 billion. Estimates from other firms are even more scant while most are still raising capital to grow. This could mean that they are not successful enough to generate enough internal profits to expand or have grand ambitions that will take time to reach fruition.

    The main issue is that the social media firms mentioned already are still private, which means they don't have to issue public financial statements. In other words, it is hard to tell if the billion dollar valuations make any sense, and the fact these companies are young and still growing means even if financial details were known, it is tough to predict how high sales or profits may go.

  2. Illiquid Securities
    The other part of being private is that these social media firms don't trade on public markets. This means there should be sizeable discounts for their lack of liquidity. This would obviously change if and once these firms go public, but the fact that the valuations are so large and the shares don't trade publicly are definitely matters to consider.

  3. Rapid Price Rises
    In his book "The Great Crash: 1929," economist John Kenneth Galbraith's described the "basic and recurrent process" of investment bubbles. He explains that rising prices attract attention, which drives the price even higher until "for reasons that endlessly will be debated, the bubble bursts." In Galbraith's mind, just the fact that social media values have risen rapidly is cause for concern and could mean a bubble has formed. (To learn more, see our Market Crashes Tutorial.)

The Bottom Line
Any of the above social media firms could turn out to grow fantastically large and profitable and could end up making the current values being placed on them look cheap. Facebook is so large that it could easily earn many billions in profits from its global network of users. However, for the reasons cited above, the entire space could be considered a bubble and most, if not all, could end up bursting and hurting investors that come in at such lofty valuations. (Want to know more about the names behind these companies? Check out Top Social Media Entrepreneurs.)

For the latest financial news, check out Water Cooler Finance: You're Never Too Old To Work.

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