.Com Bubble Bust 2???

Editor’s Note: This is what happens when the Fed pours trillions of hot funny money into anything that moves. Pretty soon firms that hold goat races in Antarctica will have P/Es of 100…

Talk of bubble trouble is rife again in Silicon Valley. Private internet companies with names barely known in the financial world a year ago are suddenly the focus of heated price-talk – even if they have yet to prove they can raise money at some of these lofty levels.

Zynga, a social gaming company valued at about $5bn by private share sales little more than three months ago, is looking to raise a fresh round of capital at a valuation of $9bn or so, according to one person familiar with its plans. Groupon, the group-buying site that turned down a $6bn buy-out offer from Google late last year, is entertaining pitches from bankers looking to take it public this year at a value of $15bn-$20bn. And Facebook, the social networking site that only last month was accorded a $50bn valuation in a deal led by Goldman Sachs, is said to be considering helping its staff sell some of their stock, at a valuation of $60bn.

Given how quickly figures like these have escalated in a matter of weeks, it’s tempting to write it all off as the product of an overheated market, made worse by a lack of much real information about the performance of these private companies.

Such a blanket dismissal would be to ignore the bigger forces at work. Social networking and the mobile internet are changing the nature of online behaviour, and technology sea-changes like this have a habit of throwing up new leaders – though they are often also an excuse for a good, old-fashioned investment bubble.

There are three basic tests for the new band of internet darlings: whether they have found a profitable revenue model; whether the markets they are creating will turn out to be big enough to support their valuations; and what impact competition will eventually have on constraining both their growth rates and profit margins.

On the first two counts, there is already evidence of some powerful forces at work. Groupon, according to one person familiar with its finances, anticipates that its revenues could double this year, reaching $3.5bn-$4bn – roughly half of which the company pockets, with the rest going to the merchants who are its customers.

By one estimate, meanwhile, Zynga is expecting revenues this year to jump by 150-200 per cent from the near-$1bn it reached last year. The group, which makes most of its money from selling virtual goods to people who play games, such as FarmVille, while on Facebook, also has a highly profitable business model.

Zynga’s success has a knock-on effect on Facebook itself: thanks to the 30 per cent tax it collects on revenues Zynga generates from Facebook’s users, a large chunk of the games company’s earnings fall straight to Facebook’s own bottom line.

By this test, Twitter, the micro-blogging site, still remains the most glaring example of a consumer internet company whose value is based more on hope than business achievement. In spite of an effort nearly 18 months ago to shift its focus to making money, Twitter’s revenues are still projected to reach little more than $100m this year. Talk of its value has ranged widely (and wildly) in recent weeks, from $4bn to $8bn or more.

But are the growth rates and profit margins of these new stars sustainable in the face of rising competition? This is where things get harder to call. With low barriers to entry, the internet can be a ruthless place. E-commerce has turned out to be a highly price-sensitive endeavour, where volume counts – and there are already powerful players to contend with.

The bull case rests on the “category killer” argument: that network effects, brand recognition and the chance to reach massive scale faster than the competition combine to give the early players in any new online market an unassailable lead.

This theory is about to be put to the test. Groupon’s conspicuous success with offering “daily deals” on the internet seems to have put it in the crosshairs of every e-commerce and local advertising company around. The test will be whether it can reach significant scale quickly enough to withstand the inevitable decline in its margins.

Zynga, meanwhile, is in the hits business – a precarious place to make a living, as many games companies have discovered to their cost. Through massive data-mining of the online behaviour of its users, and by cross-promoting new games to its already sizeable audience, Zynga is now out to show that it can insulate itself against the vagaries of online fashion.

Even if the early category killers can support their valuations, what of the many other start-ups hoping to follow in their wake? Much of the money being thrown at private internet companies is in search of new markets, or at “me-too” companies that hope to emulate the success of others.

The history of the dotcom bubble illustrates the risk that goes with this kind of wishful thinking and copycat investing. There will be winners – but a lot of blood will get spilt along the way.

Read more at Andy Sutton’s Extemporania