Thursday, 8 November 2012

The Linkedin Share Is A Speculative Bet On The Future


Linkedin (NYSE:LNKD) has demonstrated strong growth in revenues and income before tax during the last three years, but the current market price of the stock of $102.85 is grossly overvalued based on the earnings track record and profitability of the company. The stock at this stage is nothing more than a huge speculative bet on the future and the Linkedin stock is therefore not a suitable investment for the prudent investor.

The Linkedin stock price at the time of writing is $102.85, with a 52 week range of $55.98 to $125.50. YTD the stock has been rallying and is up 63.0% and over the last year it is up 28.1%. Since going public in May 2011 the stock price has increased 10.4%. With about 107.45 million shares outstanding, the current market cap of the corporation is about $11.04 billion. The stock currently trade at a trailing P/E of 668 according to Google Finance and at a P/B of 14.1 according to Q3 2012 financial statements. According to MarketWatch, the median forward P/E for 2013 based on analysts' forecasts is 82.14.

Since 2009, earnings have increased from a net loss of $3.973 million to an estimated $13.469 million in 2012.* Net revenues grew from $120.127 million to an estimated $891.588* during the same period. The net income margin however remains thin and is lower this year compared to last year (1.5% in 2012 vs. 2.3% in 2011) and lower than the 6.3% delivered in 2010. Return on equity (ROE) has averaged about 1.7% over the last two years while free cash flow (to firm) averaged $37.412 million.** As of Q3 2012 the balance sheet appears sound with a current asset to current liabilities (CA/CL) ratio of 2.6 and an equity to total asset ratio of 67.5%. Assuming a CA/CL ratio of 2.0 is sufficient, the company currently has excess cash (including short-term investments) of about $207.551 million. A risk on the balance sheet is the $405.793 million in short-term investment which consists of money market funds, certificates of deposit, commercial paper and guaranteed obligations of the U.S. government (according to 2011 annual report) given the current artificially low level of interest rates in the U.S.

While the company has demonstrated good growth in revenues and income before tax (after tax income in 2012 is likely to be lower than 2010), the company's track record nowhere near justifies the current market price. For illustrative purposes, assuming a P/E ratio of 17.3 in the mature stage for Linkedin (the current average of Google and Apple), real (inflation adjusted) earnings would have to grow from the current estimated $13.469 million for 2012 to $674.896 million to justify the current share price of $102.85. Assuming a net income margin of 24.5% (the average for Google and Apple), this means net revenues would need to grow from the current $891.855 million to $2.755 billion to generate those required earnings. And do remember that both Google and Apple are very profitable companies. If Linkedin over time was to deliver half the net income margin of Google and Apple (which would still be an achievement), revenues would have to double from the $2.755 billion above to $5.509 billion to generate the required earnings.

According to 4-traders.com, analysts expect earnings to be around $250 million in 2015 and roughly $400 million in 2016. This means that in four years' time earnings are forecasted to be only around 59% of the earnings needed to justify the current market price of the stock. The required earnings stream is therefore a long way out and little doubt there will also be more shares outstanding in the future as well. Earnings would hence need to be even higher than indicated above. Also, there is significant risk going forward that real interest rates will increase which would negatively affect the justified P/E multiple.

In short, almost 100% of the current share price is dependent, in the simplest sense, on future earnings being more than 50 times higher than current earnings. When paying mostly for future earnings that are substantially higher than that demonstrated by the earnings track record you should not be surprised if you lose most of your investment. Therefore, if you are an investor (as opposed to speculator), do not buy the Linkedin stock. Consider shorting it instead.

* Linear extrapolation of YTD Q3 2012 earnings and net revenues.

** Purchases of short-term investments have been added back as these are deemed excess cash.

Disclaimer: I have no positions in any stocks mentioned, and no plans to initiate any positions.

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