LinkedIn's value shows tech stock is up but relying on revenue potential is risky
LinkedIn's 109pc pop on its stock market debut last week shows investors are hungry for technology investments.
That's good news for a variety of firms hoping to go public, ranging from Russian search engine Yandex to Groupon. But pegging firms by their revenue potential is risky. Profits matter in the end.
Investors in new-to-market internet firms are certainly basking in lots of growth. When profit is currently scarce or non-existent, that turns into heady multiples of revenue.
LinkedIn is valued at $8.3bn (€9.5bn), or 34 times 2010 revenue. Social shopping site Groupon is valued at about $15bn, or almost 20 times last year's sales, in grey-market trading. And microblogging site Twitter is valued at $8.7bn, or more than 150 times last year's revenue, in private transactions.
Sometimes there's an earnings multiple to back such revenue-based metrics. Yandex is a good example. At the top of the indicated price range for its planned initial public offering, the firm would be worth about $8bn.
That's 18 times last year's sales. Yet the firm has a solid niche, with a two-thirds share of the Russian internet search market, and profits are growing rapidly.
At 60 times last year's earnings the shares would be more expensive than slower-growing Google, yet cheaper than faster-paced Chinese rival Baidu. That's rich, but defensible.
Some hot internet properties, eg Groupon, are now solidly in the black. But vanishingly small barriers to entry mean profit margins are likely to shrink. Others, such as LinkedIn, will surely struggle to generate the returns investors are implicitly expecting. Its market valuation is more than 500 times last year's tiny profit. And while sales more than doubled in the first quarter from a year earlier, expenses grew even faster. Yet across the board, valuations seem to be pinned on every company becoming a Google in its market.
But as became clear as the dotcom boom collapsed just over a decade ago, there are relatively few consistent winners -- and that applies all the more to businesses that gain from the snowball effect of an expanding network.
The still-private Facebook is looking like one of those winners. And for several years, it simply wasn't possible to place a value on the company based on earnings, since it only produced sales.
It now has net margins approaching 30pc. So revenue growth shouldn't be ignored.
But to avoid the errors that brought the last tech bust, investors need to keep profits front of mind.