Would you invest in LinkedIn according to these assumptions ?

time to 15%, the median for established online advertis- ing companies. Revenue Growth LinkedIn generates its revenues from three sources: premium subscriptions from members (20%), advertising (40%) and hiring solutions (40%). Looking at the size of the advertising and manpower services businesses, we estimated a growth rate of 50% a year in revenues for the next five years, starting from a base of $243 million last year, and then a gradual scaling down of growth rates to 3% in perpetuity. Reinvestment We assume that the firm will have to reinvest a dollar in capital to generate $2.14 in incremental revenues (which is the median across established firms in the business). Thus, dividing the increase in revenues each year by this number yields the reinvestment for that year. Operating margins While the company is currently profitable (generating $20 million in pretax operating income on revenues of $243 million), the pretax operating margin will rise over Cost of Capital For the first five years, the cost of equity is based on a high beta (1.80) and on the assumption that the firm will stay all equity-funded, meaning no debt will be issued. Reinvest ment ($ Mil) Free Cash Flow to the Firm ($ Mil) Cost of Capital (%) Discount Factor (X) Present Value ($ Mil) 1 2 Table 1. Projected Growth and Cash Flows for LinkedIn Earnings Before Revenue Operating Interest & Taxes Revenue Growth Margin (EBIT) EBIT. Year ($ Mil) (%) (%) ($ Mil) ($ MiB) Base 243 8.23 20 12 365 50.0 8.91 32 20 547 50.0 9.58 52 32 820 50.0 10.26 84 52 1,230 50.0 10.94 135 83 5 1,845 50.0 11.62 214 133 6 2,594 40.6 12.29 319 198 7 3,404 31.2 12.97 441 274 8 4,146 21.8 13.65 566 351 9 4,660 12.4 14.32 667 414 10 4,800 3.0 15.00 720 446 (33) (42) (54) (69) 3 4 (88) 57 (37) 12.0 0.893 85 (53) 12.0 0.797 128 (76) 12.0 0.712 192 (108) 12.0 0.636 287 (155) 12.0 0.567 350 (152) 11.1 0.511 378 (105) 10.2 0.463 347 4 9.3 0.424 240 174 8.4 0.391 65 381 7.5 0.364 Sum of the present value of cash flows (78) (48) 2 68 139 (203) (459.38 x 0.70) = 0.045 $7.146 billion* *Editor's Note: The terminal value here is slightly different because the EBIT in Table 1 bas been rounded. The author used a more precise number, resulting in a terminal value of $7.152 billion. Using a risk-free rate of 3% and an equity risk premium of 5%, the cost of capital (and equity) is estimated to be 12% for the first five years. (The math is 3% + (1.8 x 5%) = 12%.) After year five, the cost of capital steadily decreases to reach the stable period cost of capital of 7.5%. Expected Value and Survival Adjustment LinkedIn is expected to become a stable firm in year 11, growing 3% a year in perpetuity. There are several factors working in its favor when it comes to survival. The first is that the firm is not heavily dependent on a few key personnel for its success and is the first-mover in this segment of the professional networking business. The second is that the firm has no debt and will have a significant cash balance after it goes public, making it less likely to fail. Table 1 summarizes revenues, earnings before interest and taxes, and the present value for the next 10 years. Note that the reinvestment necessitated by growth creates negative cash flows for the first seven years. At the end of year 10, the terminal value for LinkedIn is computed assuming that the firm will have low growth (3% forever), a stable company cost of capital of 7.5% and will generate a return on capital of 10% forever. Using the following formula results in a terminal value of $7.152 billion: The present value of the terminal value is $2.603 billion, and is calculated by multiplying $7.152 billion by the discount rate of 0.364. Adding the terminal value to the cumulative present value of the cash flows over the next 10 years yields a value for the operating assets today of $2.4 billion. Adding the cash balance ($93 million) and subtracting debt ($0) yields a value for the equity of $2.493 billion. Adjust for other equity claims: At the time of the public offering, LinkedIn had 94.5 million shares out- standing, but it also had 17.8 million options outstanding, with an average strike price of $6.50 apiece. Netting out the value of the options, the value per share, assuming identical shares, is: Value per share = ($2,493 - $294) 94.5 = $23.27 Terminal Value [EBIT, *(1 + growth rate)] (1 - (growth rate + return on capital)] = (cost of capital - growth rate) [446 x (1 + 0.03)] [1 - (0.03 = 0.10)] = (0.075 - 0.03) However, the 7.8 million shares offered in the initial public offering had one-tenth the voting rights of the 86.7 million shares held by the founders. Allowing for a 10% discount, the value per non-voting share is $20.94, below the $43 per share offering price set by investment bankers for the IPO and well below the market price of $100 per share at the end of the offering day. = time to 15%, the median for established online advertis- ing companies. Revenue Growth LinkedIn generates its revenues from three sources: premium subscriptions from members (20%), advertising (40%) and hiring solutions (40%). Looking at the size of the advertising and manpower services businesses, we estimated a growth rate of 50% a year in revenues for the next five years, starting from a base of $243 million last year, and then a gradual scaling down of growth rates to 3% in perpetuity. Reinvestment We assume that the firm will have to reinvest a dollar in capital to generate $2.14 in incremental revenues (which is the median across established firms in the business). Thus, dividing the increase in revenues each year by this number yields the reinvestment for that year. Operating margins While the company is currently profitable (generating $20 million in pretax operating income on revenues of $243 million), the pretax operating margin will rise over Cost of Capital For the first five years, the cost of equity is based on a high beta (1.80) and on the assumption that the firm will stay all equity-funded, meaning no debt will be issued. Reinvest ment ($ Mil) Free Cash Flow to the Firm ($ Mil) Cost of Capital (%) Discount Factor (X) Present Value ($ Mil) 1 2 Table 1. Projected Growth and Cash Flows for LinkedIn Earnings Before Revenue Operating Interest & Taxes Revenue Growth Margin (EBIT) EBIT. Year ($ Mil) (%) (%) ($ Mil) ($ MiB) Base 243 8.23 20 12 365 50.0 8.91 32 20 547 50.0 9.58 52 32 820 50.0 10.26 84 52 1,230 50.0 10.94 135 83 5 1,845 50.0 11.62 214 133 6 2,594 40.6 12.29 319 198 7 3,404 31.2 12.97 441 274 8 4,146 21.8 13.65 566 351 9 4,660 12.4 14.32 667 414 10 4,800 3.0 15.00 720 446 (33) (42) (54) (69) 3 4 (88) 57 (37) 12.0 0.893 85 (53) 12.0 0.797 128 (76) 12.0 0.712 192 (108) 12.0 0.636 287 (155) 12.0 0.567 350 (152) 11.1 0.511 378 (105) 10.2 0.463 347 4 9.3 0.424 240 174 8.4 0.391 65 381 7.5 0.364 Sum of the present value of cash flows (78) (48) 2 68 139 (203) (459.38 x 0.70) = 0.045 $7.146 billion* *Editor's Note: The terminal value here is slightly different because the EBIT in Table 1 bas been rounded. The author used a more precise number, resulting in a terminal value of $7.152 billion. Using a risk-free rate of 3% and an equity risk premium of 5%, the cost of capital (and equity) is estimated to be 12% for the first five years. (The math is 3% + (1.8 x 5%) = 12%.) After year five, the cost of capital steadily decreases to reach the stable period cost of capital of 7.5%. Expected Value and Survival Adjustment LinkedIn is expected to become a stable firm in year 11, growing 3% a year in perpetuity. There are several factors working in its favor when it comes to survival. The first is that the firm is not heavily dependent on a few key personnel for its success and is the first-mover in this segment of the professional networking business. The second is that the firm has no debt and will have a significant cash balance after it goes public, making it less likely to fail. Table 1 summarizes revenues, earnings before interest and taxes, and the present value for the next 10 years. Note that the reinvestment necessitated by growth creates negative cash flows for the first seven years. At the end of year 10, the terminal value for LinkedIn is computed assuming that the firm will have low growth (3% forever), a stable company cost of capital of 7.5% and will generate a return on capital of 10% forever. Using the following formula results in a terminal value of $7.152 billion: The present value of the terminal value is $2.603 billion, and is calculated by multiplying $7.152 billion by the discount rate of 0.364. Adding the terminal value to the cumulative present value of the cash flows over the next 10 years yields a value for the operating assets today of $2.4 billion. Adding the cash balance ($93 million) and subtracting debt ($0) yields a value for the equity of $2.493 billion. Adjust for other equity claims: At the time of the public offering, LinkedIn had 94.5 million shares out- standing, but it also had 17.8 million options outstanding, with an average strike price of $6.50 apiece. Netting out the value of the options, the value per share, assuming identical shares, is: Value per share = ($2,493 - $294) 94.5 = $23.27 Terminal Value [EBIT, *(1 + growth rate)] (1 - (growth rate + return on capital)] = (cost of capital - growth rate) [446 x (1 + 0.03)] [1 - (0.03 = 0.10)] = (0.075 - 0.03) However, the 7.8 million shares offered in the initial public offering had one-tenth the voting rights of the 86.7 million shares held by the founders. Allowing for a 10% discount, the value per non-voting share is $20.94, below the $43 per share offering price set by investment bankers for the IPO and well below the market price of $100 per share at the end of the offering day. =