10 September 2011 at 18:48 GMT
LinkedIn, according to many, is ridiculously expensive because it trades at a forward P/E 737, according to Bloomberg. We believe this is far from the truth because market price reflects the equilibrium of expectations about future free cash flows - which is, essentially, what counts for an investor.
The LinkedIn case once again exposes the flawed P/E approach to investing as it
did in our analysis on the oil industry.
It has been said that Warren Buffett can reject your investment proposal or take you closer to the Oracle’s holy treasure chest within 24 hours. All he needs is five years of annual reports and your short description of the product with focus on its competitive advantage. Buffett begins all investigations by making simple “back of the envelope” calculations in order to gauge whether the investments fits the criteria of a decent margin of safety and a business model with a good moat (competitive advantage in Omaha language). We have made a “back of the envelope” calculation on LinkedIn in order to show you how fast you can determine the potential valuation of a company and to illustrate why the P/E ratio is irrelevant - a conclusion Buffett made decades ago.
Do "back on the envelope" calculations in 30 minutes
The table above shows you the actual numbers for LinkedIn the last five years followed by three years of estimates from J.P. Morgan (their numbers are more conservative than the mean estimate) and then three years of our own estimates. Based on these estimates, which took 30 minutes to compile, it is very straightforward to calculate an "back of the envelope" estimated market value. The assumptions behind the numbers are many and could be the background for a whole post in itself so we skip this part.
Source: LinkedIn, Bloomberg, J.P. Morgan Saxo Bank Strategy & Research
LinkedIn's estimated market value (yes we know the margin of error is large hence read our discussion about margin safety later) is the sum of future estimated free cash flow discounted at 6 percent plus the present value of the excess cash from needed for operation (current cash on balance of USD 352.9 mn. - (FY2011 revenue * 2%)) plus the future expected price in 2016 investors are willing to pay for LinkedIn's free cash flow (426.4 mn * 23x (the 23 is taken from Google's numbers - see below)) discounted back to present with 6 percent. The total estimated market value is USD 7.8 billion (or 73.8 per share including dilution) compared to LinkedIn's current market value of USD 8.1 billion (or 84.5 per share excluding dilution). Our estimate indicates a forward P/E of 73.8/(7.1/106.3) = 1,106 which is different from Bloomberg's number because we use J.P. Morgan's estimates for 2011-2013 instead of Bloomberg's mean estimates. Nevertheless, LinkedIn is overvalued given the current market price and our estimates of future free cash flows, but it is not as overvalued as a forward P/E of 1,106 would indicate on the surface.
How do we set the discount rate? As this is a "back of the envelope" calculation, which is the whole point of keeping it simple, we use approximately the same method as Warren Buffet. He normally uses the U.S. 10 Year treasury yield (trading at 2 percent) but we think that part of the bond market is highly distorted due the Fed's current monetary intervention. Thus we use the average 52 week Moody's AAA corporate bond yield which is 5 percent. Easy right? Whether it is 5, 6 or 7 percent does not matter as we introduce the margin of safety principle to the investment decision.
How do we set the future price to free cash flow per share? We took the three year average price to free cash flow per share for Google which came out at 23x and thus we concluded that investors would probably be willing to pay the same price in the future for LinkedIn if growth rates are 25-30 percent annualised.
Margin of safety is required to mitigate the margin of error in our estimates
The future is very difficult to predict and any forecasts are inherently associated with huge and exponential increasing margin of error. But without assumptions about the future it is almost impossible to form any opinion on a company’s current market valuation. In essence market prices are shaped through opinions and assumptions about the future. Below you can see the sensitivity to LinkedIn's value to the discount rate and future price to free cash flow.
Source: Saxo Bank Strategy & Research
To the inherent margin of error we need to establish a margin of safety. Normally we would go for around 25 percent, as Warren Buffett does, but with a fast growing Internet company we need a higher margin of safety to establish a large enough buffer to withstand an eventual negative mood by Mr. Market. We believe 40 percent margin of safety is required in the case of LinkedIn which implies that the stock would be interesting (given the company's underlying fundamentals had not changed in the meantime) at around 73.8 * (1-0.6) = 44.3 per share which is very close to the USD 45 per share it started at on the first trading day following the IPO.
Estimation and valuation is not science; focus instead on the moat and management
Is it unrealistic that LinkedIn could grow revenue 10 times over the next six years? Well many Internet companies have done that and more; to name two, Google and Facebook. Internet companies have huge potential in terms of scalability relative to the capital expenditures that needs to be invested and investors are willing to pay higher prices for that future growth. This also make these stocks more sensitive to any underperformance in terms of growth in free cash flow.
The reason why it is very clever just to do quick "back on the envelope" calculations combined with an appropriate margin of safety is that it's simple, but also that it's not the most important factor driving future returns (if the stock trades below your margin of safety). The most important factors are the management and competitive advantage. If you have superior product driven management and a huge moat then you on track to make great returns.
Now in LinkedIn's case the valuation looks at a bit stretched based on our quick calculations. But what if the stock was trading below our margin of safety of USD 44.3 per share, would it live up to the other factors?
The management has been fantastic so we wouldn't be afraid of that. What about the product? The company is clearly disrupting the global job-seeking market as LinkedIn is slowly building the world's largest job database with very little cost and it will be increasingly difficult for other companies to enter the industry as the switching cost for users will be relatively high (Is your boss on the new platform? What about the headhunters? Are my colleagues there?). This increasing information database is worth billions for HR departments around the world and thus LinkedIn is earning more and more on their Hiring Solutions for companies (see chart below). This will be the future growth and profit driver instead of the oft-mentioned premium subscriptions.
Source: LinkedIn 2Q Presentation
Second, LinkedIn has just begun its international expansion (see chart below) and thus the potential is still huge for the company. In that perspective it is unrealistic to estimate revenues north of USD 2 billion within the next 5-6 years; in fact it might be larger but that is to difficult to estimate at this point.
Source: LinkedIn 2Q Presentation