Back to the "good" old days

Recent furore over the IPO of professional networking site LinkedIn, no doubt substantiated by its first trading day price jump of 109% and its $ 8.95 Billion valuation, smells like déjà-vu.

Despite the considerable bout of common sense spouted by its CEO, Jeff Weiner as he was interviewed on CNBC on May 19th on the day his company started trading on the NYSE, alluding to the limited relevance of first-day performance and LinkedIn’s focus “on the fundamentals”, one can’t help but think that we are back to the merry days of 1999. Have we learnt nothing?

Besides the purchasers of LinkedIn’s post-IPO equity, there are ominous references to the kind of speculative behaviour that led to the stock market crash of 2000-2002. Back then as we approached the turn of the century, no brows were raised when sound valuation criteria, either earnings or asset-based were supplanted by more questionable variables such as “clicks” and “eye-balls”. In this instance, following the “success” (for bankers and insiders at least) of LinkedIn, financial journalists and other commentators were fast to question Price/Earnings ratios as next to meaningless.

The truth however is rather different and for the most part, unpleasant.

Valuation wise, the $ 94 per share price can spell nothing but trouble for the future. Diluted Earnings at the company are reported at around $ 3,7 Million, which translates into 7 cents per in earnings per share (EPS). Put it all together and you get a x 1342 P/E ratio. Sure, some 3 weeks have passed now and, as of the last trading day, the company has shed about $ 2,7 Billion in market cap and now sports a lower, but still outrageous, x 1040 P/E.

For the sceptics out there who expect enormous growth to justify these ratios and drag up the denominator (the “E” in P/E), you’d be wise to note that the company itself expects to break-even in FY2012, thus dashing any hope of an earnings driven price justification. Whilst optimists point to examples such as Google to underpin the LinkedIn investment thesis, there are some notorious differences between the two. Firstly, Google was very profitable ($ 500 Million in earnings in its first year as a public entity), not the case with LinkedIn. More importantly, even the mighty Google has seen its once sky-high P/E ratio and stock price decline and remain flat respectively for the since its peak in November 2007. Today it trades at a reasonable x20 P/E

Using other valuation parameters does little to appease concern as the company is, as you’d expect from an internet play, “asset-light” and therefore trades at x 48 the value of its net assets, or book value.

Despite the ample evidence of the mean-returning nature of stocks (i.e. P/E ratios of over X100 always must and will end in tears), talk abounds of further web-darling IPOs. Bankers and would be speculators eagerly await similar IPO-filing announcements from Facebook, Zynga or Groupon. Business magazines are today busy writing glowing articles on these web 2.0 companies much as they did in ’98 and ’99 with the likes of Webvan, JDS Uniphase or CMGI.

Whilst some of these new ventures will survive and indeed prosper, precedent would suggest to not bet on these names. To put it in the words of Joseph Anthony Wittreich:

“History doesn’t repeat itself, but it does rhyme”.

If the complete disregard for valuation risk, exhibited by the outrageous prices of recent IPOs and even private placements of pre-IPO entities, (of note is Goldman Sachs’s investment in Facebook at $ 50 Billion valuation in January 2011) , were insufficient evidence of an impending bubble, there’s more to show. As in previous periods where temporary infatuation with specific sectors of the economy was the norm, there are other components of the business fabric, which, as if to compensate, are blatantly ignored by the investing public.

Being as it is, with funds a finite resource, it should come as no surprise that profitable, asset-rich, brand-protected, business cycle-proof, price insensitive concerns can be found to trade at single digit P/E ratios. How else does one explain the x9 P/E ratio of Xerox?. The almost euphoric atmosphere characteristic of the “new web players” is offset by an excessive pessimism around older concerns. These days, established entities whose growth rates are not projected to exceed 50% are prematurely labelled as “have-beens”.

There is indeed a party going on (as it was in 1999) but we all know how this one will end!.