LinkedIn’s blockbuster IPO has triggered a predictable reaction: Howls of outrage that the valuation is obviously “insane” and that we’re right back in a tech bubble again.Leaving aside the broader bubble question (which I’ve addressed here), is the former assertion right? Is LinkedIn’s valuation “obviously insane”? What’s the company actually worth?
The answer to the latter question, which will tell us whether the valuation is “insane,” is going make more people angry. But here goes…
No one knows what LinkedIn’s worth.
Because the theoretical value of a share of LinkedIn’s stock (and any other stock) is the “present value of future cash flows.”
The present value of future cash flows.
Not today‘s cash flows. Not yesterday‘s cash flows. Future cash flows. Future cash flows discounted back to the present at a rate that takes into account the risk that the cash flows won’t materialise.
This is why no one knows what LinkedIn is worth, no matter how confidently they tell you they do. Because no one knows what LinkedIn’s future cash flows will be. This is also why all the howling about LinkedIn’s valuation relative to its profits last year is so silly: LinkedIn is a young company investing heavily for the future: It has not yet achieved steady-state profit margins.
LinkedIn’s past cash flows, meanwhile–which is what most people howl about when they tell you LinkedIn’s valuation is “obviously insane”–are only relevant insofar as they tell you what LinkedIn’s future cash flows might be.
What LinkedIn’s past cash flows do tell you, by the way, is that it is a real company with real products and real growth and real profits and diversified revenue streams. You can argue about LinkedIn’s value, and you can argue about what LinkedIn will do in the future, but you can’t reasonably suggest that LinkedIn is an unproven “startup” with little more than a business plan.And before you join the chorus of folks screaming about bubbles and insanity, remember one more thing: From the day tiny startups called “Google” and “Facebook” and “Zynga” and “Twitter” and “Groupon” first raised capital, people dismissed their valuations as “bubbles” and “insanity.” And, so far anyway, these people couldn’t have been more wrong.
So if you want to have a serious conversation about what LinkedIn is worth, you first need to accept three things:
1) LinkedIn is a real company, with real products, revenue, and profits
2) No one knows what LinkedIn’s stock worth, and
2) A handful of companies in LinkedIn’s industry have turned out to be worth a lot more than many people thought.
Fine. So is LinkedIn’s valuation outrageous?
There’s one thing we can say for certain: LinkedIn’s valuation relative to its current and near-term expected performance is very aggressive. The stock is trading at about 20-times this year’s expected revenue of ~$500 million. Some companies do trade at ~20-times revenue, but only extraordinarily profitable companies that are growing extremely quickly. LinkedIn is growing very quickly, and some smart investors believe that LinkedIn will eventually have super-high profit margins, but the company has yet to demonstrate this yet. So, at the current valuation, investors are taking the future profitability on faith. If they’re wrong about it, they’ll get clobbered.
And what about the future?
There are some future scenarios in which LinkedIn is worth a lot more than $100 a share. There are also some future scenarios in which LinkedIn is worth a lot less than $100 a share.
How could LinkedIn possibly be worth more than $100 a share? The most bullish scenario for LinkedIn is that it’s “Facebook for professionals” and that it has only just begun its growth curve. LinkedIn is still primarily a US company, so it can presumably expand to Europe, Asia, Latin America, and other regions. Generally, professionals are easier to make money off of than consumers, so LinkedIn will presumably be able to make a lot more money per user than Facebook (it already is). If you start thinking of LinkedIn as “Facebook for professionals,” and then you observe that LinkedIn is now valued at $10 billion versus Facebook’s $80 billion, you can see that there might still be a big growth story here.
And how could LinkedIn be worth less than $100 a share? Lots of ways. LinkedIn might not be able to achieve the spectacular profit margins and growth that a 20X revenue multiple requires. LinkedIn might not be very successful expanding internationally. LinkedIn’s revenue opportunity may be smaller than it appears. LinkedIn might screw up (lots of companies do). Some other company might come along and beat LinkedIn at its own game. (Maybe we don’t really need a “Facebook for professionals.” Maybe Facebook will eventually be Facebook for professionals.) And so on.
So what is the most likely scenario for the company?
Again, it’s hard to say. (No one has a crystal ball). I, personally, would say that the most likely scenario is that LinkedIn will eventually build a nicely profitable multi-billion-dollar business. But there will probably be bumps along the way. And it may take a while to get there.
And what’s the most likely scenario for the stock?
On the bullish side, one LinkedIn investor has laid out a scenario in which LinkedIn could earn $3.50 a share in four years (2015). Using current market multiples for software-as-a-service companies, the investor thinks that scenario makes the stock worth about $125 now and $170 in a couple of years.
That is a very bullish view, and it counts on lots of things going right. It also counts on the valuations for other software-as-a-service companies staying super-high (Open Table is trading at ~90X this year’s estimated earnings, which is almost certainly not sustainable. Eventually, when the years of hyper-growth are over, most stocks trade for 20X earnings or lower, no matter what business they’re in.). And it’s not actually a huge amount of upside for LinkedIn investors, even if the investor is right, especially on a risk-adjusted basis. (To buy the stock at this level, I’d like to see a probable long-term return of 5X, not 2X).
On the bearish side, meanwhile, there are an alarming number of things that can go wrong. Even if you think LinkedIn will build a nicely profitable multi-billion-dollar business, if the company’s growth slows, the stock’s valuation will probably fall to 5X-7X revenues (this is where Google currently trades). That’s about 75% downside from current levels. And if the broader stock-market cracks, which I think it might, LinkedIn’s multiple will get clobbered even if the company is executing perfectly. (If you don’t believe that, just check out what happened to Apple’s stock during the financial crisis). And so on.
So what’s the bottom line?
The bottom line is that LinkedIn is a real company with a huge opportunity, and no one knows what the stock is worth. There are scenarios in which the stock will deliver a nice return from this level. There are also (many) scenarios in which LinkedIn will deliver a lousy return from this level–or, worse, incinerate 75% or more of investors’ capital.
Personally, I would not touch LinkedIn’s stock at this level, because I think the risk is too high. The potential upside, in my opinion, just isn’t compelling enough to offset the potential downside. (Some smart investors disagree with me, though, and are hanging on to the stock. And that’s what makes a market.)
But that’s very different than thinking the valuation is “insane.”