LinkedIn is Not Worth $8.9 billion

Normally I am loathe to write about a specific stock.  My usual focus is on equity investments for what they really are: partial ownership of a business. But LinkedIn (ticker: LNKD) shares soared in their first day of trading yesterday 104.4% (= $94.24 close ÷ $45 IPO price – 1) to close at a market cap of $8.9 billion!  This, for a company whose profits last year were a scant $15 million.  Just from that alone it should be obvious that LinkedIn is not worth $8.9 billion.

Let’s work out the math, though, to put everything in perspective.  So what is LinkedIn’s trailing P/E based on yesterday’s performance?  $8.9 billion price ÷ $15 million ’10 earnings = 593.3x.

I have written at length about what P/E ratios really mean to convey, as well as the difficulties of using P/E ratios.  But here is a short primer.

That 593.3x P/E means that for every $593.30 you spend to buy LinkedIn, they give you $1 back.  Let me ask you a question, if those were the odds at Las Vegas, would you be interested in making such a bet?  Even in the lottery you do not need to spend $593.30 to win $1 back.

So that P/E is enormous and why would you be willing to pay this kind of money for LinkedIn, assuming that you were a real investor and not a momentum-type speculator?

The usual answer is that, yes, LinkedIn only earned $1 last year, but that earnings are growing so rapidly that eventually you will make back a ton of money on your purchase of LinkedIn.  But the math behind P/E ratios is just that, math.  Meaning that we can figure out just what we are up against if we want to make money in LinkedIn.

For the following I am relying upon some fairly sophisticated math, but here are my assumptions:

• LinkedIn P/E at the beginning: 593.3x
• Investment time horizon: 5 years
• Desired compound annual growth rate for that 5 years: 20%
• That reinvested earnings grow just as fast as earnings you are paid by LinkedIn

So how fast do earnings have to grow each year for five years, on average, for you to make that 20.0% return?  A whopping 416.6%!  In other words, LinkedIn’s earnings have to be $18.8 billion at the end of year 5, or 1,255.05 x bigger than they are today.  That’s like someone who makes $50,000 per year working right now, making $62.8 million per year in five years!  C’mon!

Let’s look at this in an entirely different manner.  Yesterday, LinkedIn’s first day of trading, 30,151,000 shares were traded (i.e. the volume).  The trading range yesterday for LinkedIn was $80 to $122.70, let’s take the median price, which would be: $101.35.  So those 30,151,000 shares represented $3,055,803,850, or $3.06 billion.  In turn, that means that 34% of the company changed hands yesterday = $3.06 billion ÷ $8.90 billion.

While this may not sound like a lot, imagine if, in your neighborhood 34% of the houses were bought and sold just yesterday!  My point is that this is strong evidence of speculation and not investment.  You may say, who cares?  Why do you care?

I care, because to make money in LinkedIn you are relying on a game of musical chairs – that is, you don’t want to be the last one standing.  Let’s return back to yesterday’s peak price of $122.70.  If you were the one that bought at $122.70, hoping that you could find a greater fool to buy it at $122.71, and you held your shares just until the close of trading yesterday, you would have lost a whopping 23.2% in just several hours.  That is an enormous capital loss.

Or looked at another way, imagine that you bought at yesterday’s median share price of $101.35, you still would have lost 7.0%!

By now it should be obvious that I think that LinkedIn is overvalued.  Buyer beware!

Jason

P.S. – Don’t even get me started when Facebook becomes a  publicly traded firm!