Get ready for the next episode in the eternal cycle of investor amnesia.
Following an 11-year hiatus, venture capitalists are about to launch another wave of tech company public offerings that promise to lighten the wallets of investors with short memories. Exhibit one is Linkedin, which debuted on May 19 at $45 per share and more than doubled by day’s end.
Linkedin is a career-oriented social network that allows members to establish business contacts and circulate resumes. The viability of their business model is an open question, but the mania evident in the first day of trading is highly reminiscent of the ’90s bubble and should serve as a tocsin for investors.
Access to shares in an initial public offering is tightly restricted and granted only to the best customers of the investment banks involved, so virtually no ordinary individuals had the opportunity to buy at $45.
The very first public trade on May 19 was at $83, as these privileged customers cashed in their instant 84 percent profits and the shares began to trade.
At their peak of the day, Linkedin shares sold for $127, a 188 percent premium. Based on 2010 reported profits, that equates to a PE ratio of 747 (Google’s PE is 20).
So how does a stockholder who paid $127 expect to profit?
Suppose the investor expects a 10 percent annual return over 5 years, which implies a stock price of $204 in 2016. Of course the PE ratio must eventually normalize to a sustainable level, so let’s assume a number of 30 by 2016 (the NASDAQ composite index of tech companies trades at a PE of 21).
In order for this scenario to play out, Linkedin must produce earnings growth over five years at a rate that is virtually unimaginable. Having already announced it will lose money in 2011, it would be required to grow profits at a 150 percent annual rate between 2012 and 2016, clearly a highly unlikely outcome.
To put this in perspective, suppose the net profit per customer were to remain constant (for illustrative purposes).
Linkedin has 100 million members today. To attain that level of growth, they would need to reach 4 billion members, or 59 percent of the world’s population (note that only a third of the world currently has access to the Internet).
We have seen this movie before, but here comes the sequel.
Chris Hopkins is a chartered financial analyst and vice president of investments at Barnett & Co. Inc. His personal finance column appears every other Wednesday.
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