How the stock market learned to love the web again

October 7, 2013, 3:22 PM UTC

2013 is proving to be the year that the stock market fell back in love with the Internet. The question is whether the love affair this time will be an enduring one or just another bout of exuberant infatuation.

For years after the dot-com crash of 2000, only a handful of companies at a time were received as tech stars: eBay (EBAY) and Yahoo (YHOO) were hot a decade ago, then lost their mojo. Google (GOOG) went public in 2004 and has enjoyed mostly steady gains since, but few web IPOs that followed saw similar success.

Several years ago, a new generation of startups emerged. They were built around new technologies and features like social networking, local e-commerce and mobile apps. In time, the best of these companies listed their stocks on the public markets, and some, like Zynga (ZNGA) and OpenTable (OPEN), saw their prices rise and then fall. Fewer, like LinkedIn (LNKD) won a more durable favor among investors.

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This year, nearly all public companies relying on web-centric business models are seeing the kinds of rallies that founders dream of when going public. The most notable example is Facebook (FB). Remember when the stock was trading at $18 a share, less than half its offering price? That was only a year ago.

Facebook, more than any other company, is responsible for the recent surge in web stocks. Its share price languished for much of its first year in the market amid concerns that it hadn’t found a way to monetize mobile advertising. The company’s most recent financial report, however, showed that was changing. Since then, Facebook has seen its stock price double, spurring rallies in other companies able to draw revenue from the mobile web.

As important as the Facebook effect has been on web stocks, many of them had been rising throughout 2013. LinkedIn has risen 112%, Pandora (P) 199%, Zillow (Z) 204%, and Yelp (YELP) 285%. Even companies seen as troubled laggards in the sector are benefiting: Zynga is up 60% this year, and Groupon (GRPN) has gained 135%. (Not all recent web IPOs are thriving, however: Demand Media (DMD) is down 32%.)

This spirit of generosity toward web stocks is prompting more tech companies to file into the IPO queue, and some of these are receiving warm welcomes. Rocket Fuel (FUEL), an ad-tech company, nearly doubled on its first day of trading in late September and has risen even higher since then. And Twitter, which filed Thursday for its long-awaited IPO, is expected to be valued at $10 billion when it goes public, and it has yet to show a profit.

If Twitter’s stock rises after listing with such a rich valuation, it could add even more fuel to the rally in web stocks. And that would raise questions familiar to anyone who rode the boom-and-bust roller coaster during the dot-com years: When is a rally getting out of hand? When does a hot stock become too hot for sane investors to touch?

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Consider Facebook. The stock is currently trading at 231 times its earnings over the past 12 months and 71 times its estimated earnings for 2013. The S&P 500’s (SPX) average P/E ratio is 19. Facebook’s heady price is based on optimism that its earnings will grow quickly in coming years. But the company’s earnings have proven hard to predict so far. And historically, the practice of basing a stock’s value on profits that will come several years down the road has proven risky at best.

Yet that very attitude seems to have grown commonplace among investors in web stocks, as their valuations show. Some are at triple-digit valuations. LinkedIn has a trailing P/E of 926 and an estimated 2013 P/E of 159. Netflix’s estimated 2013 P/E is even higher: 218. Others like Zillow and Yelp are harder to value, since they aren’t expected to post a profit this year and yet are priced as if they will soon see profits grow quickly.

The web rally is a sector-wide bet that mobile devices will become a prime venue for serving ads. Many people have a mobile phone constantly at hand and gaze into them dozens of times a day, making the serving of on-the-go ads a snap and also improving the targeting of those ads as user data on their daily activities is tracked in detail.

But a lot of things could go wrong. Ad fatigue may steer users away from apps and services that advertise aggressively to keep their profits growing. A privacy backlash or regulation limiting companies’ ability to track personal data could limit how effective targeted ads become. The ad market could become saturated faster than many are anticipating. In short, stock prices are rising on an unproven, if promising, business model.

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If this sounds like Internet Bubble 2.0, it’s not. Bubbles happen on broad scales, where an irrational and momentum-minded mindset takes over an entire market. What we’re seeing is a departure from sane fundamental analysis in favor of irrational hope among a relatively small segment of the market. But that doesn’t mean it’s sensible investing, or that the irrationality won’t grow in time into a mania.

One thing that could help spur a mania is if individual investors — burned twice in the past 15 years by the dot-com bubble and the fallout of the the even bigger housing bubble — are seduced by soaring prices of Facebook and its peers. After all, these are also brands that many people are familiar with and use everyday. And small investors are comfortable investing in what they know.

Which in itself isn’t a bad approach to investing. What is harder — but perhaps more important — to know is when a stock is too expensive to bother buying. We may be reaching that point soon with web stocks, if we’re not there already.