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February 19, 2014

Idea Of The Week: Linkedin’s Current Valuation – Justified Or No?

by Steven Carroll.

“Never try to catch a falling knife” has been a stock market euphemism for decades, but also should be remembered during the mature phase of a bull market, particularly with stocks that don’t appear inexpensive. We’re going to take a look at LinkedIn Corp. (LNKD.N), as recent disappointing earnings numbers have caused the stock to correct. Before rushing in at the repricing of this high-growth staple, check overall performance for the last two years.

The chart on the left shows the performance of the S&P 500 over the past two years – and its massive surge thanks to Fed liquidity and an improving U.S. macro backdrop for housing and reduced unemployment, the twin fuels of GDP growth as they drive consumer confidence and retail spending.


The chart on the right shows the S&P in pink/purple – and you can now see the comparative 1990s style price surge that LNKD has experienced, with the P/E trading in a massive range between about 210 and 90 times earnings, currently at about 110.

This time, it’s different

Stocks and indices can remain at elevated levels for a long time and it’s often difficult to spot the turning point at which to take risk off the table. However with an ARM score of 4 (placing it in the bottom 4 percentile for North American stocks), LNKD is clearly no longer delivering continuous increases in earnings forecasts. In fact the average EPS revisions for the 2014 fiscal year (ending Dec. 31) is down 27.8% and 23.8% for 2015. One bear has a 2015 EPS forecast over 50% below the consensus! The sell side remains smitten, or at least fond, of the stock – seven strong buys, 15 buys and 16 holds. As yet, no intrepid analyst has managed to whisper the sell word.


Look, it’s a paradigm shift!

Yet after the massive reset in expectations, the stock still trades at the kind of premium associated with cult status, new technologies, game changers, this time its different, etc. We admit that the stock is in a high growth phase and it may yet monetize its many assets effectively (meaning profitably) but the StarMine calculated implied growth for the stock is 32.7% growth for the next five years. If it achieves that, then the stock is just fairly valued.

So in order to risk buying at this share price, you should be anticipating EPS growth every year for five years in excess of that. The law of large numbers says that gets increasingly difficult – as any Apple Corp. (AAPL.O) disciple buying in 2012 will now ruefully admit. Here’s the APPL chart to remind those who believe the four horsemen of technology (Apple, LinkedIn, Facebook and Amazon) only go up.


The tough questions

So the questions are – will LNKD management justify the massive premium built into the current share price? Can a conservative investor or a steward of someone’s retirement assets take that gamble? They’re interesting questions — as the market cap increases, fund managers simply get more and more nervous about underweighting such key stocks.

However, it is as the share price rises that such contrarian thinking becomes the safer way to make money. As the ETF industry flows continue to grow (and often just buying based on market cap and liquidity) the active investor is expected to be more active and nimble – else why the fee? This is, after all, the justification of the active fund industry – to make these tough calls.

So far, the stock is still trading within its valuation range – but it’s a tough call to see where the outperformance comes from, in light of the current valuation /expectations.


Canary in the coal mine?

So far the short positions for LNKD remain subdued – although noting the large positions around January 2012 that presaged a significant rally, it’s possible that “once bitten, twice shy” explains current positioning as well.


Falling growth trend

What is clear is the stock is volatile with expectations that already require a lot of good news and successful execution. The final images show declining YoY growth at both the revenue and EPS level – a trend that would seem quite worrying to a current shareholder, and in stark contrast to the expectations embedded in the current valuation.

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