Is It Crazy to Invest in This Super-Expensive Stock?

At the beginning of 2012, I set out to form The World's Greatest Growth Portfolio.  Though I can't promise it will always live up to its moniker, the portfolio has returned 23% in just 11 months, beating the S&P 500 by about 9 percentage points.

A few weeks ago, I outlined exactly how I would go about building my portfolio for next year: Invest first and foremost in companies that demonstrate exceptional levels of innovation, with special emphasis given to those that I believe will be around decades from now.

Today, I'm going to look at LinkedIn (LNKD.DL), a company that I left out of my growth portfolio in 2012, and am considering adding this year.

Read all the way to the end, and I'll offer access to a special premium reports on one of LinkedIn's biggest potential competitors.

Let's deal with the elephant in the room
OK, we'll get this out of the way before going any further. LinkedIn trades for an insane 720 times earnings. If it makes you feel any better, it trades for just 112 times free cash flow !

Kidding aside, it's important to recognize two things. First, LinkedIn is just barely profitable, and with such a small denominator in the price-to-earnings ratio, the company is bound to look ridiculously expensive by this metric.

The second thing to realize is that the company has no problem growing revenue; the reason that revenue isn't dropping to the bottom line isn't because there's a bad business model at play -- it's because the company is actively investing in its future.

Over the first nine months of 2012, LinkedIn increased revenue by 89%, but the cost of those revenues only increased at 56%. That differential means that if the company wanted to make a quick buck, it would be rolling in the dough right now.

But that's not the case: LinkedIn is looking to the future. It increased spending on marketing by 103%, and product development by 100%.  If spending a lot of money on marketing -- especially when that money goes to a group that goes around pushing the service on foot -- sounds like a waste, think again.

The field sales staff focuses on introducing companies to LinkedIn's Talent Solutions division (more on that below). Versus online sales for the company, field sales tend to be longer lasting and have higher average selling prices. In 2012, field sales were up 95% -- versus 81% for online sales -- and accounted for 56% of all revenues. I think spending a dollar today to make two tomorrow makes sense in this case.

The opportunity
LinkedIn has three different revenue streams, which makes it much more diversified than social-networking peer Facebook (META -11.40%), which relies primarily on advertisements. Here's a simplified look at what each revenue stream does for customers:

Over the past year, LinkedIn increased its registered members -- those most likely to use the Premium Services -- by 43%, to roughly 187 million people worldwide. It also increased the number of businesses using the website's recruiting tools by 87%, to 13,784 unique customers. That's impressive, and outshines what others such as Monster World Wide (MWW) offer, but it's just scratching the surface of possible users and businesses. 

Here's how those three segments have performed so far in 2012:

Source: SEC filings 

I think Talent Solutions is clearly the most important segment to keep an eye on. Not everyone will pay for a premium service, but as long as businesses are bringing their job openings to LinkedIn, users will flock to the site and the company will continue to benefit from the network effect.

And this doesn't even speak to the international opportunity: Currently, the U.S. accounts for 64% of all revenues, even though the European/Middle East/African segment and Asia/Pacific segment grew by 98% and 140%, respectively, over the first nine months of 2012. 

What's the bottom line?
Though I clearly like LinkedIn, there's no telling where the field of human resources will be in 10 years. Knowing that, I'm most likely to give the company a Tier Two allocation -- the lowest possible -- if I include it in my growth portfolio.

One obvious threat to LinkedIn is Facebook.