By The Valuentum Team
LinkedIn's Investment Considerations
• LinkedIn (NYSE:LNKD) 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.
• LinkedIn shocked investors with its 2016 outlook, released February 4. Shares have collapsed as the firm's outlook anticipates headwinds in the EMEA and APAC regions due to global economic concerns. It expects growth in its field sales hiring solutions to slow considerably compared to 2015 rates in the year as well.
• LinkedIn has been in the news a lot lately. Though rumors suggest activist investor Carl Icahn is interested in shares, we're not so sure. It's not a company that we think Icahn would find attractive given its lofty valuation.
• 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.
• LinkedIn is a wonderful company with tremendous potential, but its price is still too far ahead of the underlying fundamentals. A look at its forward price-to-earnings ratio is enough for even the most risk-seeking investor to pause.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
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 44.5%, which is above the estimate of its cost of capital of 11.3%. 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.
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 6.8% 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 167% from levels registered two years ago, while capital expenditures expanded about 337% over the same time period.
In fiscal 2015, LinkedIn reported cash flow from operations of ~$807 million and capital expenditures of ~$507 million, resulting in free cash flow of ~$300 million, over 13x fiscal 2014's free cash flow.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that LinkedIn's shares are worth between $85-$175 each. Shares are currently trading at ~$109, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time. The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers.
Our model reflects a compound annual revenue growth rate of 23.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 62%. Our model reflects a 5-year projected average operating margin of 18.7%, which is above LinkedIn's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 12.9% for the next 15 years and 3% in perpetuity. For LinkedIn, we use a 11.3% weighted average cost of capital to discount future free cash flows.
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 $130 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.
In the graph above, we show this probable range of fair values for LinkedIn. We think the firm is attractive below $85 per share (the green line), but quite expensive above $175 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 $130 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $182 per share in Year 3 represents our existing fair value per share of $130 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.
Wrapping Things Up
LinkedIn has been a frequent 1 on the Valuentum Buying Index, so the potential of an adverse event impacting its shares has long been a part of our narrative with respect to the company. After releasing weak revenue and earnings guidance for fiscal 2016, LinkedIn's shares have plunged, but have yet to break through the low end of our fair value range. This is more a function of the high amount of uncertainty embedded in our fair value range than anything else, and we continue to warn that LinkedIn's business models remains unproven. Per the Valuentum Buying Index, we not only would demand that a stock is trading at a discount to our fair value estimate, but also one whose technical indicators are showing positive momentum as well. LinkedIn currently registers a 5 on the Valuentum Buying Index, so we're not biting.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.