Investors Shouldn't 'Like' Facebook at Current Price

NEW YORK ( TheStreet) -- As Facebook ( FB) celebrates its first anniversary as a public company, it's worth asking whether it and other social networking sites are favorable investments.

My answer is simple: Right now, they're not. In Facebook's case, it will have to raise earnings or its stock price will have to decline before it becomes an attractive investment.

Facebook taught investors so many expensive investing lessons that it's a challenge to know where to begin. I will touch on the main points.

The biggest takeaway is that when something is obvious to everyone, you can count on it not happening. Well, it seemed obvious to everyone and his brother that Facebook's initial public offering was a can't-lose investment. When unsophisticated, newly minted investors are opening up their first trading accounts to buy such "sure things," you better step away from the herd.

Everyone I talked to immediately before the IPO asked me about buying shares. I made it clear that I didn't have the slightest interest in buying them and that I would short the stock if I could. (Borrows are not available for retail traders for weeks after an IPO). Lesson: If everyone is buying right now, who are you going to sell to tomorrow at a profit?

Valuations do matter. It may seem that traditional valuations are ignored by investors in fast growing companies, but in reality it's always future expectations that are priced in. Relying only on quarterly reports, current price-to-earnings ratios and stock charts is like driving your car using only the rearview mirror. Those are valuable pieces of information for sure, but the future expectations affect the share price, not past performance.

In the case of Facebook, future expectations were ignored because investors were confusing the stock's valuation with the company's valuation.

These investors who bought Facebook shares knew and understood the Web site and platform. It's easy and fun to use, and as I wrote in Is Facebook Better Than Sex?, users get a thrill from others "liking" and sharing their content.

It may appear reasonable that if a social media company is "liked," the company will produce a reasonable return for investors. If all else is equal, that would be correct, but on Wall Street, rarely is all else equal.

Facebook has a P/E ratio of more than 500, and a forward P/E of more than 30. By comparison, the S&P 500 ETF ( SPY) has a P/E of 14.

You may say, "So what Bob. You just said it's the future expectations that matter anyway." You're right, but Facebook isn't a rapidly growing company; it's growth may have peaked.

FB Revenue Quarterly Chart FB Revenue Quarterly data by YCharts

LinkedIn ( LNKD) also has a sky-high valuation.

Its financials appear stronger than Facebook's, but it's not easy to make money buying companies with nosebleed P/Es. LinkedIn's forward P/E is an eye-popping 85.

As a general rule, stocks with P/Es of more than 20 underperform stocks with P/Es of 20 or less. That should tell you everything you need to know.

If you buy growth companies with enormous P/Es, you are starting out with the odds against you. In order to have an edge with growth stocks, you need to know more than the person who's selling the shares to you.

If you can't articulate why you're smarter than the seller of the shares in any company, you could be the one who is being outsmarted. If you're going to invest in social media companies, than do so by being smarter than the seller.

To get a real edge, have the patience to buy when the forward valuation justifies the price and buy on dips. In the outstanding book Analysis of Financial Statements by Pamela Drake and Frank Fabozzi published by Wiley you can learn more about what you need to know to gain your edge in the stock market.

I'll be the first to admit that the book isn't nearly as fun as reading updates by your friends on Facebook, but there's no free lunch on Wall Street, and you can bet your counterparties are putting the time and effort in to make money.

For those who want a buy price, consider scaling in slowly in the teens. Facebook's current stock price is $26, so you may get bored sitting and waiting for it to meet your entry target. But as I am fond of saying, it's much better to experience boredom than losing money.

At the time of publication, Weinstein had no positions in stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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