The Dilution Will Make LinkedIn Even More Overvalued

| About: LinkedIn (LNKD)

LinkedIn (NYSE:LNKD) is one of the hottest stocks of 2013, which is marked by a rally induced by the Fed's never-ending printing behavior. Year-to-date, LinkedIn's share price is up 117%, giving the company an almost ridiculous valuation. As if the company's valuation wasn't high enough, the company's dilution keeps increasing at an alarming rate because it pays many of its employees generously through stock options (in addition to issuing new shares in order to raise more money). In the long term, this act can't be any good for the investors.

LinkedIn's revenue growth rate has been slowing down since the third quarter of 2011 when it reached the peak. In the third quarter of 2011, LinkedIn's year-to-year revenue growth rate was around 125%. In the next quarter, this figure fell to 105%, followed by 101% in the following quarter. In the second quarter of 2012, the company's revenue growth rate was 90%, which fell to 80% in the third quarter and stayed there in the fourth quarter. In the first two quarters of this year, the company's revenue growth continued to slow down to 60%. While still strong, this number is probably already more than baked in the price of the company, as it trades for 714 times its earnings, 25 times its book value and 23 times its earnings. LinkedIn's current valuation is very high and it suggests a lot of hope that was built in.

Currently LinkedIn has about 112 million outstanding shares and the number increases by about 1 million per quarter excluding any additional share issuances. Coupled with slowing growth, the dilution might be worrisome moving forward.

They say that insiders can sell their stocks for any given reason, including paying off a house, divorce, diversifying their investments and for spending habits. Recently, LinkedIn had a lot of insider selling but it was mostly brushed off by the longs due to the argument that insiders could sell their shares for any reason. While I am usually not worried about insider selling behavior, it makes me worry when it results in a significantly higher float. If the insider selling at LinkedIn continues at this pace, it will be one of the major contributors of the dilution for the company.

Since 2011, LinkedIn's margins have improved by a couple percentage points. The company needs much stronger margins in order to justify its current high valuation. Currently, LinkedIn's EBITDA margin is just under 25% compared to Facebook's 43%. Obviously LinkedIn still has a lot of work to do.

LinkedIn is expected to earn 35 cents per share this year, $1.04 per share next year, $2.31 per share in 2015 and $3.05 per share in 2016. Even though this represents an almost 10-fold growth in a few years, it still gives the company a forward P/E ratio of 82 for 2016. The investors that are putting their money in this stock will be hoping to see some share appreciation, which means that the forward P/E ratio is likely to be even higher. In fact, if we factor in a dilution of 1 million shares per quarter, which has been going on for a while, we get even higher P/E ratios, as this would dilute the shares by 14% between now and 2016.

In 1999, there was a massive stock bubble, led by the internet companies. Today, we are seeing similar patterns with many internet companies like LinkedIn, Pandora and Yelp with high valuations. These companies may or may not see a lot of growth in the next several years, but the best case scenario is usually already baked in the current share price for most of these companies.

Currently, my strategy with the internet stocks is to go long straddle or strangle with them. For those that don't know, this is an option strategy where one buys both calls and puts of the same company, sometimes at the same strike price (called straddle) sometimes at varying strike prices (called strangle). This allows for an investor to profit from his or her investment regardless of which direction a stock moves to, as long as the stock price's movement is volatile enough. Basically, we are betting on volatility, which is a given with the internet stocks like LinkedIn. Even if one is bearish on a stock, they can use a straddle strategy in order to protect themselves in case the stock price continues to go upwards in the short term.

I will be writing more pieces to inform the readers how well this strategy works for me as time goes on and I have a better chance of observing the performance of the strategy.

Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I'm long calls and puts of LNKD. Although I am bearish on the stock, I am protecting my position by hedging it with a call option.

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