With a market cap of about $30 b and only $1.25 of LTM revenues and $40.2 m of net income, LinkedIn (LNKD) is unarguably overvalued by all traditional metrics. However, overvaluation itself is not a good enough reason to short a stock. First, one needs to examine the possibility that the fundamentals will catch up to the price, that is to say the intrinsic value of the business will rise dramatically until current or future valuation is justified. Second, the dreamers of today are most likely to be the dreamers of tomorrow. As several value investors indicated before, if the current valuation of the company makes no sense, why should we assume future valuation make one?
In the following post I will address the possibility of fundamentals catching up to valuation using a more "holistic" approach which examines the possibility of any rapid growing business to achieve such high growth rates for an extended period of time.
Peer comparison: maintaining high growth over an extended period of time
Since its IPO in May 2011, LinkedIn was able to achieve triple-digit or high double-digit Y/Y revenue growth, turning it into one of Wall Street's sweethearts and certainly the best performing stock in the social networks industry. As can be seen in the table below, LinkedIn recorded 100.6% y/y growth during the first quarter of 2012, 80%-90% growth in Q2-Q4 of the same year, and 59.4% growth during its most recent earnings release (Q2 2013).
To find out where LinkedIn's growth is headed one should not be guessing how many new users it will be able to add, how it will monetize them or when will it hike prices, but simply combine logic and history, as many other companies have walked this path before.
The table below presents the quarterly y/y revenue growth for some of the best Internet growth companies in the last couple of decades. All of them were and still are great companies, most of them were able to add more revenue streams as their business progressed, and all of them were growing at some point in their history at the levels LinkedIn has grown in the last couple of years.
The "Zero Period" was determined for each company as the last quarter in which it presented a triple digit growth or close to it, once the business was already "matured" (I excluded early stage quarters in which revenues were lower than $100 m). For example, the Zero Period for LinkedIn is the first quarter of 2012, in which its revenue grew by 101% compared with Q1 2011. Zero Period for Google (GOOG) was the fourth quarter of 2004, Zero Period for Baidu (BIDU) was the fourth quarter of 2010, etc.
Please note that this table is not at all about valuation, but simply an indication of how difficult it is maintaining this kind of rapid growth over time, no matter how good of a company you run. Going into the 3rd year after growth has peaked (8h quarter in the table), Google was the only company out of the five able to keep its rapid growth at a dazzling pace of 67%, while Yahoo (YHOO) was struggling to grow at even 20%, Zynga (ZNGA) saw a revenue decrease, and eBay (EBAY) and Baidu were able to grow at a pace of 40% y/y. And again, we need to remember this is an elite group of some of the best growth companies in the world during the last couple of decades, while LinkedIn has not yet proved to be amongst them.
Enter valuation. The importance of LinkedIn's future revenue growth derives from its premium valuation, as LinkedIn currently trades at an EV / LTM Revenue multiple of 22.5. Applying this multiple on the above mentioned companies, in the case that an investor had purchased their stock on the same stage as LinkedIn is in right now (i.e. the end of the fifth quarter after Zero Period) will have the following results:
Hypothetical share price when purchased (USD)
Current share price
The table shows that under LinkedIn's current revenue multiple investment in Google would have resulted in the best return with a total yield of 62% over 7.5 years, or 6.6% per annum. Investment in eBay under the same condition in July 2004 also had a positive return of 21%, but only 2.1% per year. Investment in Yahoo, Zynga and Baidu would have resulted in a capital loss of 57%, 90% and 8%, respectively.
What we can learn from looking back at some of the best growth companies in the internet sector throughout the last 20 years, is that maintaining growth rate of above 40% over time is extremely difficult, and a privilege only reserved for the best of the best. If an investor expects to earn a positive yield of more than 6.6% per annum when investing in LinkedIn under current valuation, he should notice LinkedIn will not only have to prove itself as one of this elite group, but probably has become a bigger success story than Google itself.