At the height of the Internet stock bubble, people paid absurd valuations for any ".com" stock. Companies with no earnings, and business models that didn't seem to plan for any, acquired billion-dollar valuations.
Now, investors as a group are less foolhardy - perhaps because the least prudent ones lost most of their money in bubbles. But Mr Market is no more a rational valuer of companies today than when Benjamin Graham lampooned him in The Intelligent Investor in 1949.
LinkedIn is not directly comparable with the companies of the Internet bubble because it has earnings - substantial, and rapidly growing, earnings. It made net income of $15.4 million in 2010, $11.9 million in 2011, and $21.6 million in 2012 (the 2012 income, and other 2012 figures below, are unaudited data from the company's announcement on February 7). It has a scalable business model: much of the value it delivers to its users comes from data generated by those users themselves, resulting in beneficial network effects.
Most of LinkedIn's revenue comes from recruitment services, which it calls "Talent Solutions." This generated $524 million in revenue in 2012, compared with $258 million from advertising and $190 million from fees to users for premium subscriptions. This is not only the largest, but also the fastest-growing, part of LinkedIn's business, having doubled in a year.
Clearly LinkedIn is a successful enterprise, worth a substantial premium to the valuation, which would apply to a less dynamic company. Investors should be willing to pay more than the 10 to 20 times earnings that they would pay for an established business. In fact they appear to be willing to pay ... let's see, 13.3 billion divided by 21.6 million ... a P/E of 615, based on 2012 earnings. For this to be justified, net income per share would have to double every year for the next six years. The company's guidance for 2013 does not project a figure for net income, but only for what it calls "adjusted EBITDA," which is forecast to rise to about $320M for 2013 from $223M in 2012. With some reasonable assumptions this could in fact correspond to a doubling of net income; but it is a one-year projection. Let us consider what further assumptions would be necessary for the company to achieve the same exponential rate of growth for six years.
Income growth is driven by growth in the number of users. LinkedIn had about 202 million members at the end of 2012, about 72 million in the USA and 130 million elsewhere. Clearly it cannot double the number of U.S. members every year for more than two years; within that time the market will be saturated. In theory, there is more scope to double the number of non-U.S. members, but not every year for six years: there simply aren't enough people. Of course, this does not in itself mean LinkedIn can't double its net income every year - it could charge more for its services, for example, or add more services - but it does bring the assumption of six-year exponential growth into question. For example, it is difficult to imagine that customers in India, China and Indonesia (which is where most growth in the number of users must come from) will be willing to pay more than customers in rich countries are willing to pay today.
However, let us suppose that all this is possible, that a sufficient number of users and recruitment agencies want the services that LinkedIn provides, and that the recruitment agencies are willing to pay in proportion to the number of users they can reach. Would this justify LinkedIn's current valuation?
It would not, because there are two further assumptions that must be made, and the first is that LinkedIn remains without effective competition in this business for the next six years. LinkedIn's business, while impressive, is still relatively small by the standards of the giants of the Internet world. It has a near-monopoly in its niche, with what Warren Buffett would call a "moat" resulting from the network effect referred to earlier. But some potential competitors have enough resources to compete - if they should choose to do so:
Net Income, $millions
Cash + Short-term investments, $millions
* The reason Facebook's net income was so low for 2012 is that it spent $1.4 billion on research and development. This is more than five times as much as LinkedIn spent on development.
+ 2011 data
LinkedIn is a relative minnow in this comparison. However, its large market capitalization makes it an unattractive takeover target. The risk that a well-funded competitor could challenge LinkedIn's dominance is clearly substantial; if it did, how would LinkedIn fare?
Facebook had about 1.06 billion active users at the end of 2012. Of course most of them did not join Facebook for professional links, but it is much easier to sell new services to existing users than to recruit new users. There is also a matter of demographics to consider. Facebook has greater penetration among young people than LinkedIn has; I don't have reliable statistics on this, but my impression is that in the USA at least, almost everyone in the 18 to 30 age-group is on Facebook, to the extent that anyone in that age-group who is not risks being regarded as "weird" or "a loner" by peers. The capability to market services to that age-group would be a powerful advantage for Facebook.
Google also could be a dangerous competitor. It controls a significant part of advertising on the web, it has a big enough war-chest and talented people to compete in any field it chooses, and has already shown willingness to branch out into many other fields besides search. It has not so far developed much of a presence in web recruitment, but perhaps that is because hitherto the market has been so small - if it had captured all of LinkedIn's 2012 net income, that would have added little more than 1% to Google's bottom line. But if this market is really set to grow by more than 50 times in the next few years, Google might be interested.
A second assumption is that the nature of employment remains more or less the same, worldwide, as it is in the United States today. The growth of Elance (a privately held company) challenges this assumption. Elance's business is based on matching contractors with businesses that want to hire temporary employees.
To sum up: LinkedIn is currently priced as though it can grow exponentially for at least the next six years; this projection is implausible to begin with in a finite world, but in addition it ignores every possible risk, ranging from changes in business conditions and changes in employment patterns to the impact of competition. LinkedIn could turn out to be a profitable speculation, but so could plunking your money on the roulette table at Las Vegas. Neither of them is a rational investment.
Needless to say, several commentators disagree with me. Derek Hoffman on Wall Street Cheat Sheet has a positive take on LinkedIn. And according to an article that appeared in The Street on February 6, none of the 29 analysts covering LinkedIn rated it a sell.