10-Year Growth Needed To Justify LinkedIn Price

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Investors responded to last week’s earnings release by LinkedIn (LNKD) by bidding up the company’s shares to fresh highs, celebrating the report that (after accounting for special items) the social networking firm earned a profit of 38 cents a share. The news – and the details of that earnings report – caused analysts to revisit any remaining bearishness with respect to LinkedIn. Youssef Squali, for instance, who covers the company for Cantor Fitzgerald, said in a note that he has had to back away from his previous designation of LinkedIn as a “runaway stock” not worth chasing at it climbs higher.

“We don’t mind being forced to (chase those stocks) in rare cases where a company keeps outperforming expectations and where the long term outlook keeps getting better,” Squali argues, having concluded that LinkedIn is just such a business.

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The earnings season rally has almost certainly squeezed out some of the shorts who hadn’t already been pushed out of this stock, incurring big losses in the midst of its year-long rally. Still, it isn’t impossible that they will end up having the last laugh. If LinkedIn was priced for perfection before this most recent break to the upside, its valuation is even more absurdly out of line with reality now, trading solely on the power of momentum.

The simplest investment analysis suggests caution. Consider the PE ratio, for instance. On a trailing basis, LinkedIn’s stock now trades at more than 600 times earnings, while the S&P 500’s PE ratio hovers closer to its traditional 15. Is LinkedIn likely to grow more rapidly than the broad market? Almost certainly. Is its rate of growth likely to be so extraordinary – on a consistent basis, over the long haul – to warrant such a tremendous discrepancy? Well, it’s not impossible, but as the old saying has it, when you hear hoof beats, think horses, not unicorns.

Looking at a trailing PE ratio can make a stock look overly pricey, but in LinkedIn’s case, matters don’t improve all that much when you compare its current stock price to analysts’ forecasts for earnings for the next 12 months. Regardless of which set of estimates used, the conclusion is that investors are paying $100 for every $1 of future earnings.

Does this make sense; is it rational? Clearly, LinkedIn has been able to deliver growth in both revenue and earnings that greatly exceeds that of the S&P 500. Currently, Thomson Reuters has pegged second-quarter S&P 500 revenue growth at 2.1%, while profits are 4.3% higher than in the year-earlier period. In contrast, LinkedIn’s growth on both top and bottom lines has been significantly more impressive – but is it enough to warrant a valuation of ten times that of the index? After all, revenue was up 59% in the second quarter, while net income rose 32%.

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The reaction to a reduction in the growth rates for both Facebook (FB) and Apple (AAPL) should be vivid enough in the memories of investors to inject some caution at this point. All it will take is one miss in the company’s execution, and the momentum-oriented argument in favor of still higher prices will collapse. By some calculations, LinkedIn will need to grow at a pace of more than 35% annually for it to be end up being fairly valued relative to the market in a decade’s time.

In other words: to rationalize its exorbitant valuation today, LinkedIn will need to deliver – consistently, over a prolonged period of time – results that are at least as strong as those it just announced. Granted, the company has demonstrated its ability to establish itself as the ‘go to’ professional social networking site, to make an effective leap into the mobile networking universe and to ‘monetize’ the value of its users. But one of the reasons it has been able to grow so rapidly is that it is still a relatively new company in a relatively new sector of the economy – and that very newness brings with it its own set of risks. New technologies or new forms of networking that we can’t imagine today – the ‘unknown unknowns’ -- are more likely to emerge suddenly and affect a company like LinkedIn than they are a veteran pharmaceutical company or the likes of Campbell Soup (CPB).

If you’ve owned LinkedIn for a while without taking some of your profits, this might be a great opportunity to do just that – if you can afford to deal with the tax consequences. If you’ve kept your holdings to a reasonable portion of your portfolio by selling small chunks of stock as the share price has soared, well done. If you’ve missed the company’s incredible stock performance over the last year, this may not be the time to start chasing it: the risk has increased, and while there may still be further upside ahead, the gap between the two is narrowing.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.


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