Linked in Case Essay Example for Free

Linked in Case Essay When attempting to determine the valuation of LinkedIn it helps to understand some of the issues involved. The most accurate way to value a stock’s price is using discounted cash flows. The problem with this approach is that it is nearly impossible to predict with any accuracy what the long-term cash flows are for a given company; especially a company that is young or that might be using an innovative and new business model. Additionally, knowing what long-term cash flows look like requires knowledge of the long-term growth rate, operating margin, weighted average cost of capital, discount rate and reinvestment rate. This makes using discounted cash flows especially difficult young companies. The discounted cash flow, in Exhibit #1 below, shows an imputed value of $109 per share versus the current market price of $246 per share. This calculation is based on an industry average weighted average cost of capital of 10% and a discount rate of 4%. However the key point is that the model assumes that revenues will grow from $972M in 2012 to $4,029M in 2018 or 415%. The fact that the market price is higher than $109 per share indicates that investors believe that the potential for revenue growth is even higher than 415%. Another potential valuation issue relates to LinkedIn’s revenue recognition method. LinkedIn recognizes its Hiring Solutions Revenue from job postings when the posting is displayed or over the contract period, whichever is shorter. This may cause revenues to be overstated in the current year if a contract runs into the next fiscal year. The overstated revenues would be extrapolated and multiplied into the future causing investors to over value the stock. In 2010 Hiring Solutions Revenue accounted for 42% of total revenues. There are many factors that can cause investors to increase or decrease their valuation of a company. One important characteristic that impacts a company’s valuation is competitive advantage. LinkedIn is believed to have high barriers to entry as it takes time for members to build their network which makes members reluctant to start over with a competing product. This creates a low membership turnover environment for LinkedIn. These two characteristics often cause investors to forecast steeper revenue growth rates and thereby assign a higher value to a stock. Another important characteristic that impacts a company’s valuation is gross margin. Companies like LinkedIn that have a high gross margin generate more  cash which causes a higher stock valuation using a discounted cash flow analysis. All things being equal, gross margin percentage should have a direct impact on the price to revenue multiple. As we can see from LinkedIn’s financial statements its gross margin increased from 75% in 2008 to 87% in 2012. EBITDA as a percentage of revenues has a similar effect on the discounted cash flow stock valuation. An increasing EBITDA to revenue ratio over time will cause a larger stock valuation. As we can see from LinkedIn’s financial statements its EBITDA to revenues ration increased from 8.9% in 2008 to 14% in 2012. The rate of growth in sales units is also an important characteristic considered during valuation. Obviously, the faster you are growing, the larger, and larger future revenues and cash flows will be, which has direct implications for a DCF. High growth also implies that a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. This is especially true when the company being valued has a very large customer base. A large customer base makes a company less dependent on any one customer for its revenue. The business model of LinkedIn is based on the revenues per user. Therefore the number of active people on this social network is the crucial factor in the company valuation. Still, the number of new members LinkedIn is adding each year is slowing. Membership increased 36 percent in the first quarter from a year earlier, down from 39 percent in prior period and 43 percent in the third quarter. LinkedIn is compensating for the trend by adding mobile and web services to keep users on the site for longer. The disposable income of a company’s customers can also impact its valuation. LinkedIn is sometimes described as Facebook for professionals. One important difference between Facebook and LinkedIn relates the disposable income of its members. Generally, professionals are easier to make money off of than consumers, so LinkedIn will presumably be able to make more money per user than Facebook. LinkedIn is still primarily a U.S. company, so it can presumably expand to Europe, Asia, Latin America, and other regions. However, the revenue per member is still much higher for U.S. members than members outside of the U.S. Competitors and market share also impact valuation. LinkedIns Talent Solutions group continues to win share from Monster.com. Sales increased  90% to $161 million last quarter while sales at Monster fell 10% to $211 million. LinkedIn shows signs of becoming the preferred recruiting tool. Increasingly, users are willing to pay for greater access as indicated by last quarter’s 79% increase in membership revenue which was $59 million. Also, the global expansion has pushed membership over 200 million users, up from 100 million in March 2011. After discussing the various issues and factors effecting the valuation of LinkedIn there are many reasons that I would not buy the stock. I believe that the current market price of $246 per share, which reflects speculated growth rate over 500%, is way too optimistic. Even at the $109 price reflect in the Exhibit #1 discounted cash flow the growth rate would have need to be over 400% which I feel is still too high. LinkedIn acknowledges they have a short operating history in a new and unproven market, which makes it difficult to evaluate future prospects and may increase the risk that it will not be successful. Linked in also acknowledges that even if it can achieve a 400% growth rate that it could still fail in its ability to build the infrastructure to reliably and securely meet this demand. I also do not like the risk of investing in a company like LinkedIn where management holds a controlling interest so that the minority shareholder cannot influence management. LinkedIn also has no plans to pay dividends so investors have no possibility to get any return on investment without selling their stock. Lastly, while LinkedIn is a market leader in professional networking it does have some large competitors including Viadeo, XING, Monster and even Facebook. Some investors worry that if Facebook decided to pursue the professional networking market that it would easily overcome LinkedIn. For these reasons I feel that LinkedIn represents a very high risk investment and many current investors are likely to lose money.