What Does The Sell-Off In LinkedIn Tell Us About The Future?

| About: LinkedIn (LNKD)

Is there anything that can make a hot stock fall? Bad news usually does the trick. Bad news in the form of a large seasoned equity offering (SEO) can be particularly effective. LinkedIn (NYSE:LNKD), which sells for about 25 times book value and 150 times expected earnings for 2013, and which has more than doubled in value since the start of this year alone, gave up some ground yesterday in reaction to the company’s announcement that it will soon issue more equity.

Numerous research studies published over many years have documented that, on average, stocks post negative and statistically significant risk-adjusted abnormal returns upon the announcement of an SEO. One early study titled “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have,” was written by Stewart Myers and Nicolas Majluf. It was published in the Journal of Financial Economics in 1984. The authors argued that when firms need funds to finance new investments, they prefer to use internally generated funds first. If that isn’t sufficient, they issue debt. And if issuing debt is not a viable option, they resort to issuing equity. In other words, issuing equity is their last choice.

The preference for issuing debt over equity and using internally generated cash flows over issuing debt is commonly referred to as the “pecking order” theory of financing. However, managers might prefer to issue equity, even if they don’t need the money right away, as long as they are convinced that the equity is overvalued. After all, why not issue stock if investors are willing to overpay for the stock? If you understand that, you understand half of everything you need to know about investing: Buy low and sell high.

If investors are smart enough to catch on, they would become suspicious when a company announces a massive SEO. As a result, you should not be surprised to see a sell-off is reaction to an SEO announcement. Perhaps this explains what is going on at LinkedIn. The mere announcement that the company plans to issue about a billion dollars worth of new stock sent the shares lower by almost three percent.

Interestingly, LinkedIn actually has two classes of common stock. The company is only planning to issue more of the Class A shares. The Class B shares, which carry 10 times the voting power, are conveniently controlled by Reid Hoffman, the company’s co-founder, former CEO and current chairman. Following the offering, Hoffman will control 59% of the votes at LinkedIn, keeping secure his role of de facto decision maker.

The announcement date damage has been done, but is it possible to form some expectation of how the shares of LinkedIn might perform over the next five years or so? Of course, every company is unique. What happens on average does not always apply to every firm. Yet the average can certainly help us form an informed expectation.

An unpublished paper called “Do Stock Prices Underreact to SEO Announcements? Evidence From SEO Valuation” suggests that we should not expect LinkedIn to perform particularly well over the next five years. The authors, Amiyatosh Purnanandam and Bhaskaran Swaminathan, conclude that stocks that are overvalued in comparison to their peers (read LinkedIn) suffer less of a decline on the announcement date of an SEO than stocks that are undervalued relative to their peers. Unfortunately, they perform worse over the next five years.

In other words, today’s almost 3% sell-off in LinkedIn will not make the longs happy, but it could be dwarfed by the stock’s possible underperformance over the longer term. Based on the Purnanandam and Swaminathan study, LinkedIn’s best days (as far as stock price performance goes) are probably behind it.