Chris Moreno, CFA's  Instablog

On Wednesday of last week (4/12), Morgan Stanley published a positive report on LinkedIn (LNKD) and raised their target price to $115 (vs $105 previously). The stock jumped 8% from the previous close on the report.

Upon closer inspection, I believe the DCF used to arrive at the firm's $115 target price contains errors, which I estimate overstate LinkedIn's valuation by over 30%. Using their cash flow estimates, but correcting for the errors detailed below, I arrive at a $77 estimated target price. I have contacted the analyst with a copy of my analysis, but have received no response.

The biggest driver of the delta between my analysis and theirs is that MS makes no adjustment for share dilution, despite forecasting share count growth of between 2-4% per year. I believe MS's share count growth assumptions appear reasonable given that LinkdedIn has guided to 7-9% of revenue going to stock-based comp. The growth in share count, while small on a percentage basis, has a real impact on valuation, particularly in the out-years.

While I can't reproduce MS's DCF exactly, their disclosures are sufficient to build a very close approximation (I'm happy to share my model upon request). My analysis takes their cash flow estimates and makes the following four adjustments:

1. Adjust NPV of unlevered FCFs For Share Count Growth - Management has guided to 7-9% share-based comp as a % of revenue, which implies about a 2% growth in share count per year. While there is no cash impact from issuing shares it does dilute an existing shareholder's ownership stake so needs to be factored into analysis when estimating equity value. I do this by discounting MS's unlevered FCF on a per share-basis. MS has estimated that share count will grow from 112 shares today on a fully diluted basis to 135 shares by 2020. I use these estimates explicitly. The cumulative effect from discounting the next 8 years back on a per share basis has about a 2% impact on valuation.

2. Adjust Terminal Growth Rate For Share Count Growth - MS's terminal growth rate appears to only consider the estimated growth in unlevered FCF, which overstates the estimated growth rate of unlevered FCF on a per share basis. Assuming that the share count continues to grow at 2% annually, MS's estimated terminal growth rate of 6% drops down to 4% on a per share basis. Assuming that share count continues to grow at 2% seems like a reasonable assumption for a technology firm and is consistent with MS's estimated 2% share count growth rate in 2020. The impact of adjusting the firm's terminal growth down by 2% for share count growth has about a 18% impact on the overall valuation.

3. Adjust the Terminal FCF Estimate To A Per Share Basis - I estimate that MS calculates their terminal value using their 2020 unlevered FCF estimate and growing that estimate by their terminal growth rate of 6% divided by their discount rate (12.5%) less their terminal growth assumptions. They then NPV this calculation back to today's dollar and divide by the current share count. I believe the correct way to calculate this would be to divide by the estimated 2020 share count (which MS estimates to be 135 shares). Making this adjustment has a about a 9% impact on valuation.

4. The roll-forward factor should be 113% (not 117%) - The roll-forward estimate is MS's way of discounting their cashflows back to the current period and then estimating what the valuation will be 1 yr forward. While I'm having trouble backing into their 17% adjustment factor, the way I would calculate it is to discount each period back 1yr less than would be used to discount back to the current period. So for example, instead of discounting 2013's unlevered cash flow per share back 1.5 years, I would discount it back 0.5 years and so on. Making this change across all periods implies a 12.5% roll-forward factor, which is consistent with the discount rate MS uses of 12.5%. The total impact of using a lower roll-forward rate is 4%.

The cumulative effect of making all of these changes lowers MS's valuation to $77, which is 30%+ below the published target price of $115. At $77, the LinkedIn is well out of buy territory given that it currently trades north of $100.

I have a completed excel model that highlights each of these changes a bit more clearly than can be communicated in text. My analysis is shared at docs.google.com/spreadsheet/ccc?key=0AoO....

While I've chosen to highlight these errors in MS's analysis, not adjusting for share dilution is a ubiquitous error across the street, meaning that nearly all analysts' target prices are overstated by about 30%. MS just provided me with enough disclosure such that I was able to highlight the impact of making these changes much more specifically.

In the interest of full disclosure, I am currently short the stock. While I like LinkedIn as a company, I think the valuation is excessive and I think that most valuation estimates are inappropriately adjusting for the very real impact of share dilution.

Please leave any comments or questions you have below. Feedback always appreciated.

Disclosure: I am short LNKD.