Social media companies are the hottest fashion on Wall Street and valuations are soaring. As the economy shows signs of improving, a new wave of IPOs is expected around 2013. Large venture capital firms are looking to get in ahead of the game, and are paying incredible sums to get a pre-IPO stake. Are these companies worth the price, or is this internet bubble 2.0? (IPO ETFs are a relatively new way to better invest your money - but there is some risk involved. Check out IPO ETFs Inside And Out.)

TUTORIAL: Basic Financial Concepts

The biggest news in social media is Goldman Sachs and Digital Sky Technologies' recent $500 million investment in Facebook. The blockbuster deal was done with an implied valuation for the company of about $50 billion. This puts Facebook's market value in the same league as pharmaceutical retailer CVS Caremark(NYSE:CVS) ($49.5B), automaker General Motors (NYSE:GM) ($47B), or the global banks Credit Suisse Group (NYSE:CS) ($50.8B) or Deutsche Bank AB (NYSE:DB) ($55B).

The Wall Street Journal reports that some Facebook employees recently sold their stock privately at prices implying a valuation closer to $75 billion, almost equivalent to McDonalds (NYSE:MCD) ($80B).

In December 2010, Twitter raised $200 million in venture capital at a price valuing the firm at $3.7 billion. Private trading of Twitter shares has since upped the valuation to around $8 billion. This is about the size of Delta Air Lines (NYSE:DAL) ($7.4B), CarMax Inc (NYSE:KMX) ($7.5B) or U.S. Steel (NYSE:X) ($7.6B).

In November 2010, Google offered $5.3 billion to acquire Groupon. This buyout offer was rejected, just a month later, however by the three-year-old coupon site. Was the offer too low? A Forrester research analyst reported told the Wall Street Journal that he believed that a multi-billion dollar valuation for the company was "absurd."

But markets can stay irrational for some time. Reuters reports that Groupon is contemplating an IPO valuing the company at around $15 to $20 billion. This valuation would put Groupon in the same neighborhood as Northrop Grumman (NYSE:NOC) ($18B), Pacific Gas and Electric (NYSE:PCG) ($17.8B), Alcoa (NYSE:AA) ($17.7B) or grocer Kroger Company (NYSE:KR) ($15B).

Zynga Games is the creator of some of the most popular apps on Facebook. In particular, it is known for the games Farmville and Cityville. The firm is contemplating an attempt to raise $250 million in private equity, with an implied valuation of around $7 billion to $9 billion, according to the Wall Street Journal. If successful, this valuation would put Zunga roughly the same range as Harley Davidson, Inc (NYSE:HOG) ($8.9B), and JCPenney Company (NYSE:JCP) ($8.6B).

LinkedIn is a social media site geared a career-oriented networking. In mid 2010, LinkedIn Corp raised approximately $20 million from a hedge fund at an implied valuation of over $2 billion, according to Bloomberg.

This valuation put it in the range of car rental chain Avis Budget Group (Nasdaq:CAR) ($1.9B) and nutrition store retailer GNC Acquisition Holdings (NYSE:GNC) ($1.9B).

Are They Worth It?
Whether these companies are really worth these high valuations is hard to say. All of the social media companies are unproven in terms of their long-term profit-generating capacities. But there are basically two views on why anyone would pay these high valuations.

The first view is that from a fundamentals standpoint, it may be that venture capital firms are valuing the firms based on projections of extremely rapid earnings growth that is expected in the coming years as these firms mature. The alternative view is that these deals are made primarily with the hope that a buying frenzy in future social media IPOs will allow them to sell at a tidy profit.

The Bottom Line
In the end, venture capital firms will not care which of these views wins out in the market, just so long as prices are higher when they sell. (The CFA Institute provides members with a variety of ongoing career and networking benefits. See Ongoing Career Benefits For CFAs.)

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