LinkedIn (LNKD) may be doing well... incredibly well at that. But the market has this one wrong. LinkedIn is not worth $165 per share, or where it's currently trading at. We think it is worth far less under even generous future assumptions. LinkedIn is a good example of the myriad uses of the discounted cash-flow process in that it shows when valuations get completely out of whack. Let's dig into LinkedIn's valuation.
Our Report on LinkedIn
• LinkedIn earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 72.5% during the past three years.
• LinkedIn operates the world's largest professional network on the Internet in over 200 countries and territories. On its website, members create, manage and share their professional identity and build out their professional networks in order to facilitate a more productive and successful career.
• Although we don't think the firm's valuation indicates an attractive investment opportunity at this time, we'd take a closer look if the firm's share price fell below $45. The market seems to be pricing greater long-term revenue growth and profit expansion than we think is achievable.
• LinkedIn has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 4.1% in coming years, and the firm had no debt as of last quarter.
• LinkedIn's business model is relatively unproven, and historical growth has masked all cyclicality, which may be severe. Competition from a variety of fronts could overwhelm the firm's network effect, inevitably disrupting its business model. The trajectory of future growth and profitability are other key uncertainties.
• The firm experienced a revenue CAGR of about 23% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (GM:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. LinkedIn's 3-year historical return on invested capital (without goodwill) is 72.5%, which is above the estimate of its cost of capital of 12.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. LinkedIn's free cash flow margin has averaged about 10.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At LinkedIn, cash flow from operations increased about 138% from levels registered two years ago, while capital expenditures expanded about 30% over the same time period.
Our discounted cash flow model indicates that LinkedIn's shares are worth between $45.00 - $134.00 each. The margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $89 per share represents a price-to-earnings (P/E) ratio of about 217.8 times last year's earnings and an implied EV/EBITDA multiple of about 68 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 37% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 23%. Our model reflects a 5-year projected average operating margin of 17.4%, which is above LinkedIn's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 26.7% for the next 15 years and 3% in perpetuity. For LinkedIn, we use a 12.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $89 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for LinkedIn. We think the firm is attractive below $45 per share (the green line), but quite expensive above $134 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate LinkedIn's fair value at this point in time to be about $89 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of LinkedIn's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $128 per share in Year 3 represents our existing fair value per share of $89 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements