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 (. 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.
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