From its fabled founding in Reid Hoffman’s living room in 2002, LinkedIn has focused on an important real market: building its member base to more than 100 million users by the time it went public.
With the IPO, LinkedIn left the world of reality behind and entered the world of expectations. The IPO was priced at $45 per share, but once on the market, the new shares immediately shot up in a bubble-worthy buying frenzy, going as high as $122.70 before falling back and, dare we say, “stabilizing” in the $90 range. That makes LinkedIn’s current market capitalization $8 billion.
What does that mean for a non-dividend-paying company such as LinkedIn? Let’s assume that shareholders have an after-tax cost of equity of 7 percent (a conservative number). Such a scenario means that investors would reasonably expect LinkedIn to generate about $560 million of incremental value for shareholders in the next year. But how reasonable is the expectation?
LinkedIn management doubled real revenue earned from $120 million in 2009 to $243 million in 2010 and converted a loss of $4 million to a profit of $16 million. That represents real and immediate value created for shareholders and a foundation for future growth. But $16 million is a long way from $560 million.
Even if LinkedIn is able to dramatically grow over the next three years, assuming heady growth rates in which revenue doubles and net income triples each year, it would earn $48 million on $250 million of revenue in 2011, $144 million on $500 million in 2012 and $432 million on $1 billion in 2013.
All told, that averages out to $208 million a year. By almost any measure that would be impressive growth. But, given current expectations of $560 million per year in shareholder value creation, that impressive growth would work out to a three-year expectations deficit of more than $1 billion. In other words, LinkedIn could grow net income 27 times over three years and still massively disappoint the market. To meet current expectations, it would have to generate 82 times profit growth in the same period.
Maybe this is the next Google. Except that even Google grew net income only 29 times in the first three years after its IPO. So maybe this is the next Google, but tripled! No doubt LinkedIn has a tough, if not impossible, road ahead to meet the newly established market expectations.
This is the nature of its new world. On May 19, LinkedIn crossed a huge gulf into the expectations world, where chief executives react to and attempt to satisfy the expectations of faceless public shareholders, regardless of how disconnected from reality those expectations might be.
Now, LinkedIn’s leaders will be tempted to focus on stock price, earnings estimates and shareholder value instead of focusing on growing the fundamentals of their business. That’s the danger they face from the “success” of the IPO: turning their attention from what made them successful in the first place to matters largely outside their control.
Everyone will be better served if management focuses on what it can do: Build the business for the long term, regardless of short-term expectations.
Martin is dean of the Rotman School of Management at the University of Toronto.