1. Thereare several strong assumptions that lead to a high valuation of the company.LinkedIn has clearly developed a disruptive business model, which fundamentallychanges the talent recruitment process by adding social relevancy and currentlyholds a leading market position with worldwide presence. Moreover, due to high switchingcosts for members, being the first of its kind in US to go public and havingvast amount of resources would potentially translate to more growth in itsmembership base and market share.
The market for hiring solutions was said tobe $27.3 billion which serves as a potential explanation why investors believethat its earnings will grow in the future. Year-to-year, companies are more andmore using social media platforms for recruitment purposes. Significant sourceof revenue comes from corporate customers and LinkedIn has saw a continuousrise in them. The IPO success is partially explained by this because investorsassume it will also grow in the future. The company is able to leverage itsexisting vast resources and market position to expand into new markets such asEurope, Asia and Latin America where Internet penetration rate is on the high.It also might leverage its network to expand into new product areas.
LinkedInpossesses a good revenue base in the USA, which can be used to start itsinternational venture. Increased page views (97% from Q4 2009 – Q4 2010) is akey indicator of the increase in revenues from marketing solutions. Assumingpage views will increase in the future it marketing revenues will also rise.Demographics of LinkedIn’s members proved to be of high advantage having higherincome and more likely to be highly educated and to be employed. Internetadvertising was on the rise reaching $120 billion by 2016.
That said, it couldserve as a key driver for increasing in revenues in the future. Having competentmanagement team which has proved capable of attracting top talent in terms ofproduct developers and engineers significantly impacts the performance of anyonline Internet company. The beta of 1.5 ishigher than the majority of the comparable companies have (Exhibit 16). Thisaffects the assumption about WACC and thus discount rate in the DCF valuation.We believe that it is reasonable as LinkedIn has a short operating history in anew and unproven market. Currently, LinkedIn hashigh revenue growth and it might pose a difficulty to sustain it in the future.For instance, LinkedIn might not be very successful at expandinginternationally or other competitors might rise and put pressure on LinkedIn’sperformance.
At the same time, another potential threat would be that Facebook decidesto enter the professional segment. Overall, LinkedIn will have to maintain thesignificant fees it charges to corporate customers while growing its corporatecustomer base significantly from five thousand customers to tens of thousandsover the next few years. Moreover, LinkedIn will need to maintain or grow itsjob post pricing in the face of competition. A continuous growth in the memberbase, an increase in the amount of information that LinkedIn members share andthe originality of that information will be crucial to maintaining demand fromrecruiters and business for LinkedIn’s services. 2. Webelieve that using comparable companies and different multiples is not reallysufficient in this case. First of all, LinkedIn is a high-growth and a rapidlychanging company so in our opinion using multiples as a valuation method is notthat useful as we are not able to capture the growth potential of the company.
Secondly, there are only two companies, Viadeo and Xing AG, that can beconsidered as “true” comparables as they have similar business models. However,despite the fact that data about two companies is definitely not enough to use thecomparable companies valuation method, there are several issues we need toconsider. These companies are not in the same size range and LinkedIn has moremarket power and thus growth opportunities.We believe that usingcompanies operating in industries such as eCommerce, online recruitment orsocial network giants like Facebook is also useless as they either havecompletely different business models, different primary sources of revenue(advertisement vs hiring solutions), completely different sizes, operatingmargins and growth projections and opportunities. That being said, weused discounted cash flow analysis to value LinkedIn.
One of the main drawbacksof this method is that it requires a lot of assumptions. That is why, weconstructed three different scenarios to see how sensitive LinkedIn enterprisevalue to our assumptions. First of all, we needto choose the projection period. In our opinion, young internet company likeLinkedIn cannot mature in 5-10 years, that is why, in our DCF analysis we projectedcash flows for 20 years, where first 10 years is the growth phase and next 10years – maturity phase.
LinkedIn has threesources of revenue: hiring solutions, marketing solutions and premiumsubscriptions so one of the ways to project LinkedIn’s revenue would be theprojection of the revenues from these three products separately. However, webelieve that this method requires a lot of assumptions. Moreover, we do nothave enough information about growth opportunities within every product separately.That is why, to simplify our model, we decided to project revenues according toone of the key metrics of performance – unique users. In 2010 unique visitorsof the LinkedIn increased by 80.6% from 36 million to 65 million.
Based on thatwe constructed three scenarios. The first one is that over the growth period(10 years) this number will gradually increase to 500 million. This scenario isbased on the assumption that LinkedIn will eventually grow approximately to theFacebook level (in 2010 Facebook had 500 million active users). The secondscenario assumes that this number will gradually go up to approximately 300million at the end of the growth phase and the third scenario assumes thatLinkedIn will stay approximately at the same level in the future, growing itsunique users only to approximately 100 million. To project the revenue wecalculated revenue per unique user, which was 3.
34$ in 2009 and 3.74$ in 2010,implying growth rate of 12.1%. In the first scenario we assumed that it willgradually grow to approximately 20$ during the growth period (again Facebookwas used as the benchmark).
In the second scenario it will grow up to 13$ andin the third scenario – up to 8$. The nextimportant issue is the operating margin. As the best benchmark for the firstscenario we again used Facebook’s one, which is approximately 40%. That is why,we assumed that in the first scenario LinkedIn’s operating margin willgradually grow up to 40% during the first projected period; in the secondscenario it will grow up to 30% and it will grow up to 15% in the thirdscenario. As LinkedIn needs toupgrade their service capabilities and its CapEx grew from 11.1% to 20.6% ofrevenue in 2010, we assumed that the company will increase its capitalexpenditures in the beginning of the growth period and then they will graduallygo down over the projected period. We projected depreciation & amortizationexpenses under the assumption that they should be lower that capitalexpenditures as company needs to invest more in PP&E to grow.
LinkedIn’s businessmodel assumes that customers pay for its services in advance as LinkedIn haspretty high deferred revenue (65 million for 2010). Moreover, the amount of theaccrued liabilities is also high – 38 million for 2010. That being said,LinkedIn’s current liabilities increase by a higher rate than its assets, whatleads to the positive change in the working capital in the DCF analysis.
As company had NetOperating Losses during previous periods and used them to reduce its taxes, we didnot calculate the tax rate using Income Statement, instead we took a common forUS companies 40% tax rate. As the discount rate weused Morgan Stanley’ assumption that the cost of capital for LinkedIn is 11.5%.
We chose a higher discount rate as investing in the LinkedIn’s common stockinvolves a high degree of risk. However, we do not agree with the terminalgrowth rate of 6%. After 20 years in our DCF analysis we believe LinkedIn willnot be able to grow at the rate that is practically three times higher than theprojected growth of economy. Expected GDP growth in US in 2.5%, that is why weassumed that the terminal FCF growth rate in scenario one is 2.2%, in scenariotwo – 1.
8% and in scenario 3 – 1.2%. According to the DCFanalysis implied Enterprise Values are 18 825.3 million, 3 975.6 million and437.3 million. Percentage of Terminal Value in the implied Enterprise valuemakes sense in all scenarios as it accounts for 37.
7%, 29.3% and 26.4%,respectively. We adjusted Enterprise Value by adding Cash and Deferred incometaxes and subtracting Debt and Preferred Stock to get Equity Value and ImpliedShare Price from the DCF. In the first scenario the estimated Share Price is$199.11 (111.
8% premium to the current price); in the second scenario – $41.97(55.3% discount); in the third scenario – $4.53 (95.2% discount).3. Inour analysis we assessed the best-case outcome and the worst-case outcome. Inour opinion, worst-case scenario is not as plausible as the first two ones asLinkedIn has pretty promising growth prospects and share price of $4.
53 doesnot seem very reasonable. Even if LinkedIn is overvalued, we would still bewilling to pay more than its current price and the implied price from thesecond scenario ($41.97) because the market is not efficient and is excitedabout internet companies going public so we believe the price can still go up.As an investor we probably would not pay more than $199.11 as this implies thatLinkedIn is practically two times undervalued right now which does not seem reasonable.Moreover, in our DCF analysis for the first scenario we used Facebook as ourbenchmark, and in our opinion, there is a very little chance that LinkedIn willgrow up to Facebook level.
4. Anumber of factors might potentially contribute to a high market value ofLinkedIn shares. One potential reason is the dual-class structure of thecompany. Dual-class share structures allow the owners of LinkedIn to tap publicequity markets without having to give up complete voting control to outsideshareholders. The owners have a level of control providing relief from thedistraction of short-term performance requirements and allow management tofocus on long-term value creation. Over the past years LinkedIn has performedquite well and has delivered positive results.
Consequently, investors may notbe entirely concerned about their voting rights given the potential benefits ofinvesting in a company run by a competent and skilled management. Anotherpotential reason is the low number of shares publicly available for trading.That said, the low supply and the high demand for a high growth stock such asLinkedIn necessary will lead to a higher market value. LinkedIn has a strongpresence in a growing market and the promise of years of growth. Revenue andmembership have been doubling at an annual pace, international expansion hasjust started and no formidable competitor has shown up yet in the professionalnetworking space. Given that other social media companies (Facebook andTwitter) were still privately held in 2011, is another potential reason thatinvestors are eager to possess such a high growth social networking companystock. Furthermore, many investors have limited information concerning thegrowth of the company, thus making their opinions of growth to vary.
Last butnot least, another explanation is the low offer price of 45$ implying thatmoney has been left on the table because the large price increase suggestedthat the demand for shares exceeded the supply.