As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. Let's examine what we think LinkedIn (NYSE:LNKD) is worth in this article and whether shares are timely for new money.
But first, a little background to help with the understanding of this article, and how we think about new money. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy (at any given time -- the new money). This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies (good value, good momentum, etc.), thereby revealing the greatest interest by investors -- the most buying potential.
At the core, if a company is undervalued both on a discounted cash-flow and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. For relative valuation purposes, we compare LinkedIn to peers Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Yahoo (NASDAQ:YHOO), and Facebook (NASDAQ:FB). We understand the pitfalls of relative valuation analysis, which is why we combine the relative valuation process with a rigorous discounted cash-flow exercise. We like to take a holistic view.
LinkedIn posts a Valuentum Buying Index score of 1 on our scale (the worst), reflecting our 'overvalued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technical. The new money thinks LinkedIn will get hammered in this market environment. We prefer firms with higher Valuentum Buying Index ratings - firms that register a 9 or 10. These companies are not only underpriced on both a discounted cash flow and relative valuation basis but also are exhibiting strong technical and momentum indicators.
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio:
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 75.9% 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.
• Because of the enormous membership growth LinkedIn has demonstrated during the past several years, corporate human resources departments continue to shift their budgets toward LinkedIn over traditional talent recruitment sources. Sales of LinkedIn's Talent Solutions products have surged as a result.
• 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 magnitude of future growth and profitability are other key uncertainties.
• Though we think LinkedIn is a wonderful company with a great business model and tremendous long-term earnings potential, the price is still too far ahead of the underlying fundamentals.
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 (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 75.9%, which is above the estimate of its cost of capital of 11.8%. 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. We expect LinkedIn to invest more capital in the business as incremental returns converge to its cost of capital over time.
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 15% 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 59% from levels registered two years ago, while capital expenditures expanded about 122% over the same time period.
The estimated fair value of $135 per share represents a price-to-earnings (P/E) ratio of about 420 times last year's earnings and an implied EV/EBITDA multiple of about 75.6 times last year's EBITDA. The firm has already fallen significantly since the original date of the report, and we expect further price-to-fair value convergence. Our model reflects a compound annual revenue growth rate of 31.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 16.3%. Our model reflects a 5-year projected average operating margin of 16.3%, which is above LinkedIn's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 18.5% for the next 15 years and 3% in perpetuity. For LinkedIn, we use a 11.8% 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 $135 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 $88 per share (the green line), but quite expensive above $182 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 $135 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 $189 per share in Year 3 represents our existing fair value per share of $135 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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. GOOG is included in the Best Ideas portfolio