There has been some healthy differences of opinion in the past 24 hours about the implications of LinkedIn’s IPO. The splash has brought out another wave of individuals’ asking whether we are seeing another Internet bubble. The question has been swirling for some months now. In fact, worries of a bubble have occurred for many years. People cried bubble after Netscape’s IPO in 1995, Yahoo’s IPO in 1996, extreme valuations in 1999 (when we really did have a bubble), when Web 2.0 began to get buzz in 2005, and when facebook raised money at a $50 billion valuation in January 2011.
What bothers me is when the valuation analysis of LinkedIn stops at a comment on the shares’ price-to-current-sales ratio, i.e. “LinkedIn is trading at 24 times 2011 revenue. That’s ridiculous.” After Yahoo’s first day of trading in 2006, the company had a market cap of $848 million on projected annual sales of $1.3 million. Would buying the shares at 652 times sales in 2006 have been ridiculous? From the perspective of how things turned out, the answer is no. Yahoo’s shares now trade more than 10x higher, compared to a roughly 1x increase for the S&P 500. From the perspective that Yahoo’s results are an anomaly and it was simply imprudent to purchase shares of a stock like Yahoo’s in 1996, the answer is maybe.
But I think the right way to look at things is whether investors are assessing the future prospects for LinkedIn when determining a valuation. The ideal valuation methodology of a company is to assess the anticipated future cash flows and adjust for risk. Some venture investors tend to anchor their analyses around multiple of current year revenue. Some investors in publicly traded stocks tend to anchor their analyses around multiple of earnings based on current year or next year’s earnings. I think that these anchors are established in part because the future is hard to predict. So, one turns to what a company is able to generate now. I believe the anchors are also driven in part out of a lack of willingness to look deeply at a company in order to assess its future prospects.
I do not have enough information about LinkedIn to say whether I think it is overvalued. But I can offer my two cents on whether we are in a bubble. My sense is that markets are generally efficient in discounting future expectations. Market efficiency can break down when (A) the assumptions underlying future expectations are off (often the case given that market participants lack perfect information), (B) market diversity deteriorates and investors’ decision rules become too uniform, or (C) investors are swayed because of emotional issues. It’s this last consideration that has received a lot of attention lately.
In the bubble in the late 1990s, there were a number of emotional drivers. First, there was the lottery effect, whereby many investors were willing to put a small amount of money in Internet stocks knowing that the probability-adjusted returns were not favorable (like the lottery), but were willing to risk a small amount of cash for the possibility of spectacular returns. Second, bears became discredited by 1998 or 1999. Those naysayers who decided to not buy stocks like AOL in 1997 or advised their clients to not buy stocks like AOL in 1997 were feeling an incredible amount of pain by 1999 and were at risk of losing their jobs. By the time the bubble burst, bears were fearful of speaking (leading to both a break down of market diversity and emotional influences). And additional emotional issues were at play.
So, what emotional issues might be going on now? Are investors simply too exuberant? Maybe. But one could argue that short sellers theoretically should be driving down LinkedIn’s stock if it were clearly overvalued – though smart short sellers should know to short Internet stocks on momentum, not valuation. Are we seeing the lottery effect again? Perhaps… maybe some investors look at social media companies like facebook and Twitter gaining value rapidly and see LinkedIn as one of the few publicly traded opportunities to roll the dice with a social media company. When LinkedIn’s stock was first priced, however, I imagine that institutions drove the pricing of the stock. And institutional investors would be less likely to be influenced by the lottery effect.
And there are additional emotional considerations. All of this is to say that I believe one should consider possible emotional issues influencing LinkedIn’s shares, but one should also have a good handle on LinkedIn’s future prospects before dismissing the valuation as absurd. I think it is healthy to ask if we are seeing bubble-like influences, but I ask that individuals provide some deep analysis before claiming that a bubble is here — analysis that is deeper than simply pointing to the headline of LinkedIn’s 24-times-sales stock price.