Summary - Why This Analysis is Different
LinkedIn (LNKD) has been one of the hottest stocks and most talked about companies of this earnings season. Despite all the positive hype, the valuation has reached unprecedented levels in the post-dotcom cycle.
Many traditional valuation techniques just don't paint the picture, so we have taken an alternative approach that analyzes several "what you must believe" scenarios in order to justify the current valuation. The results demonstrate that LinkedIn would need to grow EBITDA by 4-8X and revenues would need to reach at least $2.5 billion just to maintain its current valuation.
If you then look at these "what you must believe" metrics, it should be easy to see that even with the most aggressive of assumptions, LinkedIn is a stock to avoid or short if you can stomach the current irrational momentum that has driven this stock to uncharted territory.
Common Valuation Methods Don't Paint the Picture
In a company that is growing at the recent rates reported by LinkedIn, a DCF valuation is going to be tough to support - the ultimate value will be so sensitive to assumptions of growth and discount rates, making the analysis very subjective. Similarly, P/E multiples are in uncharted territory and any reasonable comps will be hard to find.
So rather than attempt a bottoms-up or top-down valuation, we have taken the current valuation and back-solved into several key metrics and compared those with other similar companies. The result of the "back-solve" will show what you need to believe to support the current valuation. If you can believe those results are possible, then perhaps you think LinkedIn is fairly valued, however if you read the results as we do, you will see that even the most optimistic of scenarios is still far too conservative to justify the current value.
First, We Start With the Current Valuation and Peer Set
Let's start with LinkedIn's market cap as of 2/15 of approximately $17.4 billion. To put that in perspective, that value is only around 1/4 that of Facebook (FB), but nearly $3 billion more than the value of seven of other Internet superstar companies combined (yes, combined) including Groupon (GRPN), Zynga (ZNGA), Shutterfly (SFLY), OpenTable (OPEN), Kayak (KYAK), ValueClick (VCLK) and Yelp (YELP). I will not attempt to compare the $17.4 billion valuation with companies from other industries, but it is safe to say that the comparisons alone should give reason for pause.
Okay, now let's start to compare a few key metrics of LinkedIn with a few other companies. To account for differences in capital structure, I will use the "Enterprise Value" metric instead of Market Cap - the difference being an adjustment for debt and cash. I will also use EBITDA rather than net income for comparison purposes given that companies in different stages of growth can produce much different net income figures.
I started with comps to Facebook and Google (GOOG) just to ground us in the numbers. Obviously these are different companies at different stages of the maturation cycle, but the most astounding figure is the EV/EBITDA comparison - LinkedIn is more than 2X that of Facebook and nearly 10X that of Google!
I selected the next set of comps for 2 reasons - first I was looking for Internet companies with > $1B in EV and second I was looking for companies at or near the 52-week high, similar to LinkedIn. Again, the EV/EBITDA multiples are astounding. What is even more interesting is that in my search, using the 2 criteria above, there were very few other companies and none with a valuation near $17B, suggesting LinkedIn is clearly in uncharted territory.
Finally I looked at 2 other comps - both Internet companies with EV > $1B, but not at their 52-week highs. Both Zynga and Groupon were once hot, but have fallen by 80% and 71% from their highs, respectively. The point here is that while Internet companies can be hot at one time, driven by momentum and overly optimistic growth assumptions, they eventually fall back down to a justifiable value.
If we look at the EV/EBITDA across all the comp sets, with the exception of FB, the range tends to settle around 25-15, far lower than LinkedIn's current ratio of 127.
Now, Let's See What We Must Believe to Justify LinkedIn's Valuation
Now that we're grounded in the current valuation numbers and peer set, we ran a few scenarios to figure out what we must believe to support this valuation. The basic premise is that the EV/EBITDA of LinkedIn will ultimately converge to the peer set range of 15-25.
You can see that to support the current $16.7B EV, at a 25 EV/EBITDA multiple, LinkedIn would need to hit EBITDA of $666 million, or grow EBITDA by more than 400%. If the valuation converges to the low end, LinkedIn would need more than $1.1B in EBITDA - more than 8X the current level. Sound reasonable? Let's look at what sales would need to be to support this level of EBITDA.
LinkedIn currently has an EBITDA margin of 13.5%, or a ratio of 7.4 sales to EBITDA. If this ratio holds, then to reach the EBITDA needed to support the assumed EB/EBITDA range of 25 to 15, then sales would need to reach between $4.95 and $8.25 BILLION! That's right, if you believe that LinkedIn will ultimately converge to the peer valuation range, then EBITDA must grow by 4-8X and sales must exceed $5 billion.
Okay, as companies mature, margins generally improve so we looked at what revenue would need to be if margins doubled. The result is that LinkedIn would still need revenues between $2.5 and $4.1 BILLION! To put that in perspective, LinkedIn's primary competitor Monster (MWW) has revenues of less than $1 billion - so LinkedIn would need to take over the entire revenue stream of its primary competitor and still potentially make up billions more in revenue.
Conclusion - Avoid or Go Short
It is easy to get caught up in the hype of a great growth story like what we are seeing right now with LinkedIn, but every great growth story has its end and stock valuations ultimately converge to industry norms. In today's fast paced business cycle, especially for Internet companies, the period from great growth to convergence can happen very rapidly - just look at Groupon and Zynga , the Internet stars of just a year or two ago. Once the euphoria wears off with LinkedIn, we could be in for a 50-80% correction, depending on how LinkedIn is able to grow EBITDA in the short term. The timing of course is the unknown variable so if you can stomach short-term volatility, this is a great short opportunity.