Reality could already be setting in for Reddit stock after the highly anticipated IPO. 3 things smart investors should know.

Reddit had a brilliant market debut, but the company still has a lot to prove in the future.

The stock market is off to a brilliant start in 2024. This is what the euphoria surrounding artificial intelligence (AI) brings S&P 500 And Nasdaq Composite Record highs have been reached, and the momentum doesn't seem to be slowing down.

Unsurprisingly, some companies are taking advantage of ripe market conditions, as 2024 brought a number of high-profile initial public offerings (IPOs).

Social media platform Reddit (RDDT 3.89%) recently began trading on the New York Stock Exchange. While shares briefly rose more than 120% from their offering price, reality may be setting in as they have already fallen more than 30% from their peak.

Potential Reddit investors should understand the biggest areas of risk for the company and how these may impact its long-term prospects.

1. Social media is highly competitive

The social media industry is full of competition. While platforms can specialize in different areas such as product reviews, peer-to-peer communication, or image and video sharing, the underlying goal is always to build a large, engaged community.

From a business perspective, this makes sense. If you can attract more users to your platform, you have a greater chance of monetization. And the most common way to monetize users on social media is through advertising.

With 73 million daily active users, Reddit clearly has some brand appeal. Additionally, the company generated $804 million in revenue in 2023 – a 21% increase from the previous year. Similar to its competitors, Reddit's primary source of revenue comes from advertising.

On the surface, this seems like a pretty solid deal. However, Reddit is struggling with companies like Metaplatforms, alphabet, SnapX (formerly Twitter), Pinterestand others for commitment.

Meta Platforms owns Instagram, Facebook and WhatsApp, which together have over 3 billion daily active users. Alphabet is now home to the world's most visited websites – Google and YouTube – with over 100 billion page views per month.

Reddit management clearly understands that it has an uphill battle when it comes to competing with these bigger giants. The company's average revenue per user fell 7% year-over-year in the fourth quarter of 2023 after remaining flat in the previous quarter.

But the company's plan to grow beyond the typical advertising business model is puzzling and, more worryingly, completely unproven.

2. Reddit's growth path is puzzling

In Reddit's S-1 filing, the company describes two additional areas it is exploring as revenue opportunities: e-commerce and artificial intelligence (AI).

E-commerce can complement Reddit's existing advertising operations. However, the intersection between Reddit's specific brand of social media and e-commerce can be challenging given the existing players in the space.

Thanks to the rise of small businesses on Instagram and the marketplace on Facebook, Meta has been able to successfully move into e-commerce. But while smaller platforms like Snap are also experimenting with e-commerce, their success has been significantly less. Snap's average revenue per user continues to decline, highlighting challenges for social media companies looking to expand their revenue streams.

In AI, the company has signed data licensing deals worth $203 million – notably including a $60 million partnership alphabet.

Given Reddit's extensive library of user data, the idea that the platform's content can be mined to help train generative AI models makes perfect sense. However, the risk here is that these same models could end up poaching the company's user base and engagement as people turn to AI for the discussion and answers they previously sought on Reddit.

3. The stock's premium is too high

Reddit has a market cap of $7.5 billion as of this writing, which translates to a price-to-sales (P/S) ratio of about 9.3.

That's in line with Meta's P/S ratio, but higher than Pinterest and Snap. This premium valuation is difficult to justify given the question marks over its growth prospects.

Data from YCharts.

According to Bloomberg, Hedgeye Risk Management analyst Andrew Freedman recently called the stock “severely overvalued” in a short report published last week. Freedman expects the stock to move closer to its IPO price of $34 per share, which would benefit short sellers who profit from falling stock prices.

Once Reddit begins conducting earnings calls, investors will learn how successful the company is with its e-commerce and AI operations. But for now, I would stay away from Reddit and let the current hype surrounding the stock flow. Larger, more established companies offer more opportunities on social media.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Randi Zuckerberg, former director of market development and spokesperson for Facebook and sister of Mark Zuckerberg, CEO of Meta Platforms, is a member of The Motley Fool's board of directors. Adam Spatacco holds positions at Alphabet and Meta Platforms. The Motley Fool has positions in and recommends Alphabet, Meta Platforms, and Pinterest. The Motley Fool has a disclosure policy.