Why LinkedIn Is The Most Overvalued IPO

This week LinkedIn, a social networking site for professionals, went public with truly eye-popping valuations. LinkedIn's timing is excellent. They probably managed to sell themselves to the public during the late stages of bubble formation, but well before the inevitable bust.

At the peak of the tech bubble in 2000, the Price/Earnings ratio of the NASDAQ 100 was well in excess of 200. In other words, people were happy to pay more than 200 times annual earnings for the companies in the index. Even in the extremely unrealistic case that earnings double every year, it would take about 8 years to get paid back. That is why the bubble popped. Today the P/E for the NASDAQ 100 is 17.4, a sustainable value.

LinkedIn currently has a P/E ratio of 1314.

Even in the unlikely event that earnings double every year, investors would need 11 years to recoup their investment. If earnings don't grow, it would take 1314 years, about the time from the fall of the Roman Empire to today.

Other valuation measures are equally absurd. the Price to Sales ratio is 13.5 and the Price to Book ratio (measures the stock price vs. the company's assets) is 132. The NASDAQ 100 trades at a P/S ratio of 2.2 and a P/B ratio 3.5 for comparison.

LinkedIn is vastly overvalued, even compared to the famous irrational exuberance of the last tech bubble.

What About Facebook?

A similar picture emerges for Facebook. Its valuation isn't as easy to determine, because it is privately held, but by most accounts it is worth somewhere between $50 billion and $150 billion. The 2010 sales are said to have been around $2 billion and they are expected to double in 2011. Assuming $4 billion in sales and a $50 billion valuation, we arrive at a P/S ratio of 12.5. Higher valuations or lower sales would increase this already completely absurd number.

Irrational Exuberance has clearly returned to this component of the tech sector. No doubt we will soon hear that 'it is different this time,' and we may even see a return of absurd valuation measures like 'Price to Eyeballs.'

LinkedIn and Facebook would have to find a way to increase their sales tenfold in a very short period of time to support their current valuations. This is virtually impossible to do for these large and relatively established companies.

The social networking sector is ripe for a crash, just like the whole tech sector was in early 2000. It is not clear when, or how it will affect individual companies, but history shows that current valuations in this sector as a whole are unsustainable for long periods.

Posted by Martin Gremm

About the author

Marc Schindler, CFP®
Marc Schindler, CFP®

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