Valuing Young Growth Companies

In May 2011, LinkedIn (LNKD), a social media company that allows individuals to create professional and business networks, went public to great fanfare, with the stock price doubling on the offering date.

While Linkedin reported only $20 million in operating income on revenues of $243 million in 2010, the market capitalization of the firm was $10 billion on the date of the initial public offering (IPO). The reaction from investors and analysts fell along predictable lines. Value investors and fundamentalists argued that the market capitalization was absurd, pointing to the sky-high price-earnings ratio (in excess of 1,000). In reaction, investors who were bullish about the company countered that traditional valuation metrics and approaches don’t work for young growth companies.

Both groups are wrong. The traditional value investing approaches tend to attach too much weight to existing assets (and earnings), whereas the growth and momentum investors are making a mistake in abandoning valuation principles.

Shared Characteristics

While young growth companies have diverse histories and are in different businesses, they share some common attributes. First, many have limited histories, having been in existence for a year or two, or less. Second, revenues are often small or non-existent and many report large operating losses as they spend money to establish themselves. Third, most don’t survive. A study that used data from the Bureau of Labor Statistics Quarterly Census of Employment and Wages concluded that only 31% of all businesses that were founded in 1998 survived until 2005. Fourth, it is not uncommon for these companies to grant options to early equity investors (venture capitalists and private equity) that affect later equity investors.

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