Imagine a business -- any business -- with the following characteristics:
- A return on assets of -.42% -- so it continues to lose money.
- In spite of the terrible income history, in the 3 ½ years since it's been public, shares have risen by a CAGR of ~27%.
- Its operating earnings to enterprise value was 743 (i.e., an operating earnings yield of about a tenth of a percent).
- Its earnings are riddled with accruals, and quite shy on cash.
- Analysts who speak favorably of the business sound eerily like the overly optimistic dot com sirens of the late 1990s, comparing this company to somewhat similar businesses that have bloated valuations themselves.
- It has a long and illustrious history of insider sales and no insider buys. It seems that the people who know the most about the company know something that the bullish analysts don't know.
The situation LinkedIn (LNKD) investors face is a very toxic combination: a company where the shares are priced for perfection (as if zero mistakes will be made and as if they have a perfectly defensible competitive 'moat' over the next decade) and a business where net income remains strangely elusive in spite of revenue growth that is both rapid and suspiciously stable.
If this company manufactured pies, would you buy it? Would you buy it if it made cars or processed jet fuel or made bricks or did almost anything else? If the answer is 'no', you must shy away from LinkedIn. It's priced for a perfection that no company has ever achieved (because success attracts competition, because of the inability for any business to continually grow at a high compounded rate for an extended period of time, etc.). In addition to the nosebleed price of this company, the insiders themselves are sending the market a very loud signal with their serial selling activity.
To help unbundle some of the assumptions the market is currently making, one of the things we do is compare tangible book value per share to the current price. When we do this exercise for LinkedIn, the situation looks predictably unrealistic. The company's tangible book value per share growth has been impressive over the past three years. TBVPS has grown at a CAGR of ~350% over the past 3 years to $20.14. Comparing that TBVPS to the current price, though, presents a much more pessimistic outlook. In order for these two numbers to equalize, the TBVPS will need to continue to grow at a rate of ~28% a year for a decade. Given the already large user base for this company (about 332 million active members as of late 2014), one wonders where that kind of growth is going to come from (i.e. growing the user base at that rate for a decade brings us to a very unrealistic member base of 3.91 billion people).
We also apply more traditional valuation metrics. According to those, LinkedIn is a terrible investment. This shouldn't come as a surprise. Given that the company made a huge amount of cash from financing (1.45 billion in late 2013), some of the 'X to cash metrics' offer very little insight into cash from operations generating ability of the business. The following offer some useful insight, though:
- Switching over to quarterly data, we see that the shares are trading at a ridiculous 443 times free cash flow.
- Both Operating and Net Margins are low and in decline.
- Looking at Return on Assets over the viewable life of this company, we see one period that was an outlier at ROA of 17.86%. Over the past 15 quarters, Return on Assets has averaged about 1.52%. These assets would have made a better return at much less risk in a high interest savings account.
We could go on, but at some point we just start to feel sorry for the non-insider LinkedIn shareholders.
Investors should remember that they're buying businesses and not little scraps of paper that we should 'buy on the dips' or trade in the hopes of finding someone even more optimistic/delusional/gullible than ourselves. Given the current mood in the market, though, LinkedIn is being treated like a stock that people can talk themselves into buying because it's slightly less insane than some of the businesses they arbitrarily compare it to.
Our view is that buyers of LinkedIn are playing a game of 'hot potato' with increasingly small rewards for increasingly large risks. Could shares continue to rise from here? Absolutely. Such a rise would be more of a testament to mania than the application of sound investing principles, though. This business should be judged like any other investment and according to the metrics we've collectively developed to judge 'good' from 'bad', the judgement is plain: the price is too high relative to the underlying cash generating ability of the business.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.