When Value Investing Fails

Though I am definitely a value investing advocate, there are simply times when basic value concepts like fair value and margin of safety fail to provide useful conclusions in analysis. Case in point: the valuation of a fast-growing business like LinkedIn (NYSE: LNKD  ) . To illustrate, I'll attempt to find LinkedIn's fair value and its margin of safety.

Meteoric growth is hard to estimate
LinkedIn's first-quarter revenue increased by 72% from the year-ago quarter. That's impressive. Yet it presents a serious problem for value investors.

Value investors, of course, seek out the intrinsic value of a business. And forecasting growth rates for the business going forward is central to any valuation of an ongoing business. But LinkedIn's current high growth rates make forecasting the next several years very difficult. High growth rates present investors with extremely high levels of uncertainty. Difficult questions arise: When will the decline in growth rates begin? To what degree will it unfold? The answers to these two questions will drastically affect valuation.

Sure, year-over-year revenue growth rates have topped 85% in each of the past three years, making LinkedIn's high growth rates pretty consistent. But this doesn't mean we can expect revenue to grow by exceptional rates over the next several years, or even next year for that matter.

For instance, in each of the last three years, Apple's (NASDAQ: AAPL  ) revenue and EPS year-over-year growth rates topped 44%. But in the trailing 12 months, EPS is up only 1.8% from the year before. Who could have seen that coming? Apple shares have fallen right along with growth rates, trading more than 40% lower than they were about nine months ago. Apple is no longer a growth stock. In fact, at today's prices, it could make an excellent value investing candidate or even be considered a worthy dividend stock.

What is LinkedIn worth?
Ignoring the notion that growth stocks are tough to value, let's give LinkedIn a proper shot at a valuation.

Consider two different scenarios. In Scenario A, LinkedIn manages to increase free cash flow by 50% next year, followed by growth rates that decelerate by about 10% annually for the next nine years.

Year

Growth Rate

1

50%

2

45%

3

40.5%

4

36.5%

5

32.8%

6

29.5%

7

26.6%

8

23.9%

9

21.5%

10

19.4%

Given these assumptions, a discounted cash flow valuation yields a fair value of about $197 for LinkedIn shares, giving shares about an 11% margin of safety at today's price around $177.

But in Scenario B, things don't go quite as well. Free cash flow growth rates decelerate by 15% every year.

Year

Growth Rate

1

50%

2

42.5%

3

36.1%

4

30.7%

5

26.1%

6

22.2%

7

18.9%

8

16%

9

13.6%

10

11.6%

This scenario also seems realistic. Yet now investors face a conundrum. If a scenario like this unfolds, a better estimate of the fair value of LinkedIn's shares is $132, based on a discounted cash flow valuation. In other words, shares would be about 33% overvalued at today's price.

We could also explore a Scenario C, in which growth rates in excess of 40% are sustained for more than five years. In this case, LinkedIn shares would be grossly undervalued.

Herein lies the problem with applying the concepts of value investing to stocks like LinkedIn. Slight changes in estimated growth rates for these fast-growing companies present an uncomfortably wide range of fair value estimates, leaving value investors with nothing more than a headache.

Another approach
So does this mean stocks like LinkedIn do not make the grade as an investment? Not necessarily. Another way to add some context to the stock is to look at the company's addressable market.

LinkedIn's largest operating segment, recruiting, accounts for about 57% of revenue. And fortunately for investors, the segment is plush with opportunity. There's an estimated field of 200,000 corporate clients, and only about 18,000 use LinkedIn. Its recruiting segment already appears to be on a path of massive market share gains, with the segment's revenue up 80% in the first quarter of 2013 from the year-ago quarter.

In other words, LinkedIn's addressable market is huge.

Be flexible
Does LinkedIn's huge addressable market imply the stock is undervalued? No, but it does present a new way to look at its opportunities.

We have to face the fact that there's just no excellent way to find the fair value of the shares of fast growing companies like LinkedIn. Investors brave enough to put their money in these stocks should do so only with a very strong conviction of the company's competitive advantage and its addressable market. A plan to hold for a very long time is essential because the astronomic valuations pinned to stocks like these will most likely be accompanied by very volatile price swings.

Typical value investing methods may not always work. Even when they don't, there's no reason to turn a cold shoulder on a stock. Instead, change your approach and tread carefully.

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  • Report this Comment On June 26, 2013, at 10:35 PM, Mega wrote:

    "Typical value investing methods may not always work. Even when they don't, there's no reason to turn a cold shoulder on a stock. Instead, change your approach and tread carefully."

    Changing your approach when value investing isn't working is a great way to incinerate money.

  • Report this Comment On June 26, 2013, at 10:36 PM, XMFMadMardigan wrote:

    Daniel,

    Interesting article, and I get your point. But I think you're missing a fundamental (ha) element here:

    Value investing isn't intended to be a cure-all philosophy. The top value investors wouldn't struggle to determine LinkedIn's intrinsic value, they'd just file it under 'too hard.' A crucial element to value investing is choosing companies that you can model and determine if the stock has a suitable margin of safety (a flexible requisite in itself).

    Value doesn't fail, it just doesnt always apply. The beauty of it is that you can turn over 1,000 rocks, and you only have to find a handful of gems.

    Just my two cents.

  • Report this Comment On June 27, 2013, at 12:27 AM, banmate7 wrote:

    I agree with Mardigan. Value investing is designed to help you not lose money.

    I'd rather consistently win with decent gains than win or lose big. This is especially important when you stake ever larger sums of money.

    I can speculatively invest $5k. I cannot afford to lose on speculation $20k.

  • Report this Comment On June 27, 2013, at 1:42 AM, blearynet wrote:

    It sounds like you are saying that if a stock does not fit your value investing parameters, you should "adjust" the parameters. I agree with the previous comments. You can speculate with your money if you want to, of course. Just don't call it value investing.

  • Report this Comment On June 27, 2013, at 9:35 AM, Pkylie wrote:

    Lnkd is such a value stock that lnkd insiders saw fit to sell for $1.6 Billion profit todate, and they continue to sell each and every week.

    The total global market for hiring solutions is about $3 Billion, and lnkd can grow this market ?

    Only through creative accounting...

    Lnkd is nothing but a SPAM company, serving up 10 Billion SPAMs a week. Who cares about Joe Blow's work anniversary or new job or what he thinks ?

    Lnkd is like the Kardashians, no one gives a hoot but they keep injecting themselves in the news.

    Can you say Pump and Dump hype machine ?

  • Report this Comment On June 27, 2013, at 10:24 AM, TMFDanielSparks wrote:

    A lot of good thoughts here. Thanks for the great insight.

    I'd say what I was really trying to get at with this article is this: Investors should not ever feel trapped by strict dogma.

    Occasionally, an opportunity that is outside of your typical strategy may make an excellent investment. This doesn't mean you should change your approach in order to "fudge" the numbers. Instead, it simply means keeping an open mind so you don't miss an opportunity that may not fit in your typical methods.

    Is LinkedIn one of those opportunities? Not necessarily, but looking at the company's "addressable market" does provide interesting context you would never have came across had you been inflexible.

    Anyway... I really enjoyed the thoughtful comments in this thread.

  • Report this Comment On June 27, 2013, at 11:46 PM, TMFBlacknGold wrote:

    Great article Daniel. Completely agree with the premise "Investors should not ever feel trapped by strict dogma".

    Maxxwell

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