On October 30th, I discussed my analysis of The Global X Social Media ETF (SOCL), comparing it to a modern-day incarnation of the tech stock excess during the late 1990s. Even though the historical data shows that seemingly underwhelming things like GlaxoSmithKline at $40 and Conoco at $33 will go on to outperform the collection of stocks that make up the Global X Social Media ETF because the valuation differentials are now extreme, it can be difficult to be persuasive in real time when the value stocks keep going down and the trendy social media/tech stocks keep going up.
The thing about investing is that, at some point, the valuations always come down to bear a relationship to the cash flows generated from the business. I don’t have the capability of predicting specifically when this will happen, but I can identify stocks where the valuation has become so extreme that good long-term results become a near impossibility (the reason I say “near impossibility” instead of “impossibility” is because of the remote possibility that a greater fool valuation for a particular stock extends for an unusually long period of time).
When I analyzed LinkedIn back in October, here is what I had to say:
“I’m looking at SOCL, the Global X Social Media ETF, and some of the holdings are just begging for disastrous long-term returns. It has almost 10% of its portfolio in LinkedIn stock. This is not what you do when you’re looking for a high probability of gains for 15+, nor is it something you buy when you are looking for conservative asset management. It’s entirely the realm of short-term traders.
LinkedIn loses $175 million per year, and it has a market value of $30 billion. The rosiest analyst predictions call for $500 million in profits by 2020. If those optimistic predictions come true, and the stock traded at 25x earnings then, the company would be valued at $12.5 billion. You’re staring at losing two-thirds of your money if the best-case earnings scenario works out.
Ahh, but that is not the entire story. LinkedIn also heavily dilutes its shareholders, as executives receive share compensation and the company must issue new shares through primary offerings because it regularly loses so much money. It had 100 million shares in 2011, and has 130 million shares now. If you assume 165 million shares of LinkedIn will exist at the time it makes $500 million, the company will make $3 per share in 2020.
Assuming a 25x earnings valuation, that actually means the stock would trade at $75 per share around 2020. It currently trades at $240. And I should mention those are optimistic estimates. The consensus calls for under $200 million in annual profits and $1.25 per share in earnings. It’s also generally true that stocks revert towards 20x earnings as they reach maturity. The math under a scenario in which earnings greatly disappoint investors, and the P/E plummets, is an even worse story.”
Well, today was a day of reckoning for shareholders of LinkedIn. Management revised its revenue expectations for the first quarter of 2016, telling the investor community that the $860 million expectation isn’t likely to be met and LinkedIn will instead generate revenues around $820 million. That is also less than the $862 million LinkedIn earned in the fourth quarter of 2015.
On Monday, the price of LinkedIn stock was $202 per share. By Friday’s after hours trading, the price of the stock had fallen to $107. A decline of 47% in less than a week. The worst part is that it’s all justified–Linkedin shareholders deserved this economic fate because the price of the stock had become so far removed from the operational results of the business itself.
Even as this week’s decline in LinkedIn stock has restored some sobriety to the analysis of the stock, I am still antagonistic towards the media coverage of the stock (and how LinkedIn portrays the core business). They tell people that LinkedIn will earn $3.20 per share in 2016, and the media unquestioningly relays this information along to investors. Someone might pull out a calculator, take the $107 per share price and divide by $3.20, and think the stock is selling at 33x earnings–and perhaps conclude that the 47% price decline offers an opportunity to buy a stock at a nice price given it is still somewhat early in its growth story (analogous to buying Starbucks in 1993 when the P/E valuation was about twice that of the market but still cheap because of the rapid earnings growth that awaited).
No, this isn’t one of those times. I don’t like cussing on the site unless it’s necessary to get attention to avoid long-term harm, but this is one of those times: It is complete bullshit that LinkedIn and the media are reporting non-GAAP earnings to the investor community. What LinkedIn is doing is giving you earnings results as if stock-based compensation to their employees and ordinary amortization costs don’t exist. The only people who want to give you results that don’t include stock-based compensation are those that are issuing so much stock that it is diluting shareholders into oblivion.
The GAAP earnings for LinkedIn, if the $3.20 per share non-GAAP prediction pans out, will be somewhere around a loss of $0.50 to $0.60 per share. You can’t pretend that almost 40 million issued shares don’t exist. To do otherwise would be like pretending that a cookie shop growing earnings at 10% is making you richer if, during the same time, you are diluting the partners from 10 to 14. If your ownership slices of the pie are getting divided up at a greater rate than the overall pie is expanding, you are in no way getting richer by any definition that resembles economic reality.
I understand why companies find it in their interest to not include stock-based compensation when reporting results to the public, but I do not understand why the media is so complicit in relaying company-disseminated information to the public. If you think LinkedIn is earning profits of $3.20 per share, you are going to reach different conclusions than if you analyze it thinking the company is posting results of -$0.60 per share. Investors are responsible for figuring out the variables that create the numbers, but financial analysts shouldn’t be so accommodating when it comes to misleading their audience (especially when the audience possesses varying degrees of financial sophistication).
Long-story short: Graham, Munger, Buffett, Yacktman, Ness and all those other guys are still right. Earnings do have to bear a resemblance to valuation over the long term. This social media craze is creating something reminiscent of the tech bubble during the late 1990s. Because some of the currently fashionable names have been outperforming the S&P 500 for years, otherwise smart people are ignoring their better instincts and buying ownership stakes in firms trading at valuations that are completely disconnected from even optimistic projections of earnings. This eventually leads to substantial losses–the manner and timing of which is unpredictable. LinkedIn was one of dozens of dominos that needed to fall. But just because the LinkedIn domino has fallen doesn’t mean you should pick it up as a value investor looking for future growth. I have no opinion on whether LinkedIn will rebound in stock price in the short term, but I am unimpressed with the LinkedIn executives and officers that talk in terms of non-GAAP earnings. It misleads investors and severely understates the extent of shareholder dilution through executive compensation, and it is going to be frustrating when investors that think they own 1/10th of something learn they only own 1/14th of it (and the substantial dilution is still continuing).