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It was just over a year ago when Netflix (NFLX) was the top story as it continually made headline news and analysts kept raising expectations. However as of Tuesday's earnings report the company is currently worth less than a quarter of its peak valuation.

In the aftermath of yet another selloff for Netflix I think it would be prudent to start analyzing some of the similarities between LinkedIn (LNKD) and Netflix. There has been a very bullish case built into LinkedIn as evidenced by a P/E that's floating around 700. However I have read the arguments, and I am not convinced. I cannot claim years of experience however, so on top of what I believe to be very concerning fundamentals, I will also draw upon past academic papers that have analyzed high P/E ratios and the high long term growth rates needed to justify such valuations.

While Netflix's P/E only made it to about 70, a tenth of what LinkedIn is at, at the very least we can say in hindsight that it was overpriced. There are many parallels currently displayed between LinkedIn and Netflix. Notably:

  • Both were first movers in a dynamic new growth industry
  • Both received relatively high valuations, specifically in terms of P/E ratios
  • Inherent in these high valuations are high long term growth rates
  • Both have been priced to perfection: any miss in earnings would be (or in Netflix's case was) a catastrophic blow to the stock price.

The argument for investing in both at the incredibly high valuation is typically along the lines of "It's an early stage growth company in which traditional fundamentals don't apply." While I am young and can't claim decades of experience, this argument seems to be all too familiar to one that existed just over a decade ago.

Perhaps it may hold for some small cap stocks, but with billion dollar valuations, it seems rather optimistic. The papers I have included in this paper support this stance, that history has proven that investing in stocks with extreme valuations built off of high growth rates rarely pays off.

The problem with Netflix a year ago and LinkedIn today, is that the valuations completely ignore the very real threat of increased future competition. Sure, Facebook (FB) hasn't been able to compete with LinkedIn in the professional networking segment yet, and Monster (MWW) has been struggling as of late. But are we to assume they are just going to give up? No one else wants a piece? What about the fact that barriers to entry for social networks don't exist? One has to contemplate the notion that eventually competitive forces will enter the market and enact pricing pressure on LinkedIn.

It's interesting how quick people are to forget about MySpace being bought for $580 million seven years ago only to be sold off last year for $35 million. Sure, LinkedIn has a diverse revenue stream that MySpace never experienced, but that isn't something we haven't seen before. The tech bubble was ripe with examples of companies that experience exponential revenue growth and extreme valuations, only to fizzle out soon after.

If we look at some of the academic work on the subject we can see that there have been very few cases where companies have maintained the high long term growth rates that justify such valuations. In a paper entitled "Cisco and the Kids" author Mark Hirschey analyzed some of the extreme P/E multiples seen throughout the tech bubble and compared them to the "Nifty Fifty," a similar phenomenon seen around the market peak of 1972. Hirschey's findings are not surprising. Just as many of the highest valued stocks crashed after spectacular growth in the tech bubble, the high P/E and high growth technology giants of the nifty fifty all severely underperformed nifty fifty contemporaries and the overall market over the next decade or so.

Hirschey also noted at the time that the allure of tech stocks is obvious: they do well at capital spending during economic expansions, they are often exciting, innovative products unseen before, and so on. However what is often less understood and reflected upon is the enormous risks that face such new companies that may be unable to successfully anticipate and adapt to new challenges. Are we to expect LinkedIn, with half its workforce having been hired in the last year, to execute perfectly?

Hirschey also notes that there seems to exist a tendency to discount classical economic theory that in competitive markets abnormal profits tend to dissipate over time. This was all too clear in the dramatic rise and fall of NFLX. On Tuesday we even saw what may be the end of Apple's (AAPL) incredible growth story. How long will it be until the same fundamentals finally attach themselves to LinkedIn?

A second paper entitled "The Level and Persistence of Growth Rates" analyzed a sample of common stock from 1961 to 1997, with the number of firms included ranging from 359 in the first year to 6825 in the last. The purpose of the paper was to attempt to draw conclusions about sustainable growth rates. The paper illustrates some very humbling realities for high P/E firms such as LinkedIn that are summed up as follows:

  • While above average sales growth is seen with some persistence, there is however essentially no persistence in above average growth of earnings over the long run across the entire sample of firms.
  • Signs of persistent growth in earnings are slim even in cases that are popularly associated with dazzling growth stocks (pharmaceutical and technology stocks, growth stocks and firms that have experienced persistently high past growth).
  • While security analysts' long-term estimates point in the same direction as realized growth over short horizons, they are over-optimistic and do poorly in predicting realized growth over longer horizons.

Further caution for LinkedIn is evident when the authors break down the findings for small and large cap stocks. As to be expected, companies with a smaller scale of operations have more room for potential growth which possibly justifies a high multiple. Large cap firms however with a larger scale of operations are more likely to face limits in their growth and accordingly extreme high growth rates are very rare.

To remain bullish on LinkedIn and invest at these levels you basically are putting your money on the chance that LinkedIn will be the one in a hundred stock that defies classical economic theory. On that note however, if you have invested in the last year or so, you have likely made some great returns. The stock has outperformed to date and many shorts have been burned. However we have seen too many similar cases where stocks trade unattached to fundamentals for a period of time prior to being smashed back down to reality. LinkedIn may indeed continue to defy gravity for some time, but history has shown that few can do this in the long run.

Below is a daily chart of LinkedIn. A careful analysis of the patterns emerging again warrants caution to those advocating a bullish thesis. Typically a consolidation after an uptrend is a continuation pattern, and we should expect a second move upwards, however there appears to have been significant distribution selling on some of the bigger pullbacks which suggests that the looming breakout very well could be to the downside. There also appears to be significant overhead resistance in the form of a double top.

(click to enlarge)

In conclusion, it has not been the intention to have been overly critical of LinkedIn. Since Jeff Weiner took the position of CEO the company has had tremendous growth and has effectively monetised its site through three diverse revenue streams. It is a tremendous growth company that has revolutionized the online recruiting industry and been a leading social network in both growth and monetization. The company went public, and the stock has outperformed. However, as an investment, I cannot say the same. With net profit margins fluctuating between 4% and -1% over the last 5 quarters there really is no room for error. We have seen how competition crushed Netflix's stock and just recently forced the company to issue a cautious outlook that includes an expected fourth quarter loss.

The academic literature available suggests that very few companies proved to be good investments when bought at such extreme valuations. For a large cap company that just recently began showing profits, albeit within very low margins, the prospects are even worse.

To quote the famous author Mark Twain:

"History doesn't repeat, but it often rhymes.."

Source: Is LinkedIn The Next Netflix? Analysis Of High P/E And Growth Stocks

Additional disclosure: I am bearish on equities in general. All financial information relevant to LinkedIn was sourced from the 2011 annual report available at investors.linkedin.com/annuals.cfm