LinkedIn (NYSE:LNKD) is the "strictly business" equivalent of Facebook (NASDAQ:FB). It is a social network that people use to connect with each other in order to do business. Companies use LinkedIn as a sales and recruiting tool. People use LinkedIn to promote their skills, advance their careers, meet with like-minded professionals all over the world, find a new job or search for partners to help them with a new project.
LinkedIn has an effective monopoly since it enjoys the same network effect that Facebook does. The network effect works like this. The more users the company has the greater value those users enjoy. So even if a competitor launches a site similar to LinkedIn people will still prefer LinkedIn because of its greater network (number of users). This is a great barrier of entry that prevents new entrants from competing effectively with it.
However, this doesn't mean that LinkedIn operates competition-free. Besides premium subscriptions, the other services for which LinkedIn charges are essentially job posting, talent finding and advertising. So LinkedIn competes with other job posting sites and content creating sites for advertising dollars. And don't forget Facebook which is also competing for advertisements and is the best-suited company to start a rival business similar to LinkedIn's.
Since its official lunch on May 2003 LinkedIn has added 225 million members and since its IPO in 2011 it has almost quadrupled its revenue from $240 million at the end of 2010 to $970 million as of the end of 2012. Unfortunately its net income has only grown 40% in the same period from $15.4 million to $21.6 million. Despite its very low earnings LinkedIn has a market cap of $19 billion trading at $173.78 per share.
The main bull argument about this extremely inflated valuation is its super-fast revenue growth. So, to find out if we should be buying or selling LinkedIn stock this is the question to ask:
"How fast should LinkedIn grow to be a sensible investment at current price levels?"
First let me explain the term "sensible investment". As a "sensible investment" I mean buying a stock at a price that is lower or equal to the sum of its earnings for the next decade. The reasoning behind this is to simulate a 100% owner who will want to earn back his invested dollars at most within the next ten years.
Following this reasoning we find that an investor that buys LinkedIn at $173.78 and wants to earn back his invested capital through LinkedIn's earnings over the next decade, is essentially expecting LinkedIn's EPS to grow at an average annual pace of 80%. That means that LinkedIn's EPS will have to grow from $0.21 to just above $75 until 2022. Assuming a 10% net profit margin, LinkedIn's revenue must rise from $970 million at the end of 2012 to $85.5 billion at the end of 2022. This is an average annual growth rate of 56.5%.
The above back-of-the-envelope analysis doesn't discount for any possible risks along the way. If we apply just a modest 5% discount rate then the required EPS growth rate becomes 89.5% and the required revenue growth rate 64.3% (assuming of course 10% net profit margins).
So the question we should be asking changes to:
"Are those growth rates achievable?"
My answer to that question is "I don't care". LinkedIn may indeed manage to achieve this kind of EPS growth rate either through tremendous revenue growth or through margin expansion. The problem is that in order to achieve an ordinary 100% return in 10 years, investors must bet on an extraordinary outcome. If something less than so extraordinary happens (let's say 50% EPS growth) the bet collapses.
LinkedIn has a great business and may grow at an enormous pace over the years. However at its current prices it offers extraordinary risks for an ordinary outcome. This is exactly the opposite of what sensible investors should be looking for.