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Linkedin Valuation

|Includes: Microsoft Corporation (MSFT)

The share price of Linkedin Corporation (NYSE:LNKD), the online professional networking company, has had a very good run indeed this year having increased 61.5% YTD as of 14 August 2012. Since going public in May last year the shares have appreciated a more modest 9.3%. The share price at yesterday close was USD 101.76 and with 105.7 million shares outstanding the market cap of the company is USD 10.756 billion. Based on 2011 sales and earnings, the current P/S ratio is 20.6 while the P/E ratio is 903. The book value per share as of Q2 this year was 6.97 which gives the company a current P/B ratio of 13.7.

According to MarketWatch today, 12 analyst have a buy recommendation, 1 is overweight while 10 have a hold recommendation. Based on consensus forecast mean EPS for next year of USD 1.32 and the market price of USD 101.76, the 2013 forward P/E ratio is 77.09. reports consensus EPS estimates of -0.13 this year, 0.47 for 2013 and 1.33 for 2014. The forward P/E ratio for 2014 is therefore 76.5.

It is evident from the above that the market is expecting a brilliant future for this company given the high valuation. It is exactly for that reason, if you are an investor (as opposed to a speculator), that you should not buy the Linkedin share. If we apply the same calculation as for the Facebook Valuation where a "reasonable" P/E ratio of 18.8 was used, Linkedin's earnings would have to increase by more than 40 times (from USD 11.91 million to USD 572.13 million) to justify the current valuation. Further, assuming a 25.8% profit margin in line with Google (Linkedin achieved a 2.3% profit margin in 2011), sales would have to increase from USD 522.19 million in 2011 to USD 2,217.56 million to achieve those earnings. It's hard to see that happening any time soon. In addition, the company is yet to demonstrate it can even make an economic profit as evident by a very poor record for both Return on Assets (ROA) and Return on Equity (ROE). For example, ROE was 12.4% and 1.9% in 2010 and 2011, respectively, and ROE for YTD Q2-2012 is in line with that delivered last year. That is not a trademark of a great company and a great business model, certainly not at this stage.

The bottom line is that the current valuation is almost 100% dependent on future free cash flows that are considerably higher than the past and in addition the company is yet to demonstrate it can even deliver economic profits. And that is all you need to know - if you are an investor that is. As with all speculative issues, the share price could rise substantially even with little (even negative) earnings growth. But how long that would last nobody knows. All we know is that ultimately a company needs to deliver earnings and cash flow to justify the market price. If not, the market will lose faith and penalise the share price accordingly. The current valuation of Linkedin bear a stark resemblance to some of the market valuations seen during the bubble back in 1999. We all know how that ended. Do not be surprised if Linkedin loses most of its current market value in due course - more specifically, it could drop 90% or more.

Source: Google Finance, EcPoFi. The numerator for ROA and ROE has been multiplied by 2 for 1H 2012 as to represent through extrapolation an annualised figure.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.