How Do You Get Bullish on LinkedIn?

May.25.11 | About: LinkedIn (LNKD)

By now, we’ve seen countless commentaries on the assumptions you have to make to justify paying $90+ for a share of LinkedIn Corporation (NYSE:LNKD), including outrageous growth and sudden economies of scale factored into the margins. Instead of this backwards approach, let’s look at how an accurate, optimistic value should be calculated (and what that value is). In the words of CEO Jeff Weiner on IPO day, “It’s all about the fundamentals.”

Revenue. Using only the most recent quarter’s income, we extrapolate annual revenue to $376 million per year.

Growth Rate. According to LinkedIn’s S-1 prospectus, it's expecting its growth rate to decline (from its current 76% level) in the future, which is understandable as a course of normal business maturity, so we assume a 10% drop in growth rate each year resulting in a four-year annualized growth rate of 61.5%.

Additionally, I would expect the most recent quarters to have some degree of inflated numbers because of a near-term push to polish up before the IPO.

LNKD LinkedIn Valuation Model Assumptions Key Statistics
Profit and Free Cash Flow Margins. As of the most recent quarter, LNKD posted an 82% gross margin but is expecting to end the year in the red (at least according to GAAP). Looking forward toward the long-term, we’ll take out the depreciation impact and reduce the R&D by 5% to give the benefit of the doubt to its previous developmental efforts. This gives us a 9.4% longer-term free cash flow margin which, because of the software business model and the 82% gross margin, could likely move into the range of 10-20%.
With those inputs, we arrive at a market cap of $3.14 billion.
Share Count. With a given 94.5 million shares outstanding, plus 16.2 million more in employee stock options, we’ll use 102.6 million (applying half of the options) as our divisor.
Including $3.17/share of cash ($106 million in existing cash plus $219 million generated from the IPO), we arrive at a near-to-far valuation range of $30.53 to $78.33. Any higher trading price than the most optimistic valuation is strictly a supply/demand premium. Jim Cramer gave a very good explanation of the IPO tactics in play, limiting the supply to, as he said, get everything “frothy.”
[Click to enlarge]
LNKD LinkedIn Stock Share Price Chart IPOClick to enlarge
Keep in mind that the $78.33 valuation assumes that everything goes right for the next four years (20% free cash flow margin, 61% growth). Any wrinkle in that execution dials the potential valuation back down towards the $30.53 level. And now the question becomes, even if you are optimistic on LinkedIn’s outlook, why would you be a buyer at the $78 level (or above) where there is no fundamental upside?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.