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Mark Hulbert
May 24, 2011, 12:01 a.m. EDT
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) "” Pencils ready?
Here is today's math quiz:
How fast must LinkedIn's earnings grow to justify its current price?
The answer is a matter of simple mathematics. And yet, few have bothered to do the calculations.
Which is surprising. You can debate forever where you think LinkedIn's stock should be trading, but one thing LinkedIn cannot do is overcome the laws of arithmetic.
Therefore, if you are investing in LinkedIn's /quotes/comstock/13*!lnkd/quotes/nls/lnkd LNKD +5.44% stock at current levels, you implicitly are betting that the company will achieve the requisite growth rate. You might as well know what that is.
So here goes.
For illustration purposes, I will focus on the next five years "” though you could do this exercise using any other time frame as well. To solve for LinkedIn's required growth rate, you need to answer two preliminary questions:
What will be its average annual return between now and May 2016.?
What will be its P/E ratio in five years' time?
Let's tackle the first question first. Though the stock market historically has returned about 10% per year on an annualized basis, LinkedIn's stock will be much, much riskier than investing in the overall stock market. It therefore will need to provide a return significantly greater than 10% annualized in order to compensate investors for this greater risk.
To be conservative, let's say that LinkedIn's stock produces a 20% annualized return over the next five years.
Now let's tackle the second question. Companies as big as LinkedIn "” of the nearly 10,000 publicly traded firms in the United States, it's larger than all but 399 of them "” don't trade forever at a sky-high P/E. On the contrary, that ratio inevitably declines as such companies grow and mature.
To put this question in an historical context, consider that the long-term average P/E ratio for all stocks is around 15. Among mid- and large-cap companies, even the fastest-growing ones typically do not have P/E ratios higher than 30 or 40.
To again be conservative, let's assume that LinkedIn's P/E in May 2016 is still as high as 50. (It's over 500-to-1 currently.)
Guess what: With those two assumptions, LinkedIn's earnings per share will have to grow at an average rate of 91.6% per year for the next five years.
Don't like this answer? Go ahead and try playing around with the numbers. You'll be hard pressed to come up with an answer that you'll like any better.
Take a look at the accompanying spreadsheet. Each of the cells lists the required EPS annualized growth rate over the next five years to support the assumptions that are listed.
To give you an idea of how unlikely such growth rates are, consider a landmark study that appeared several years ago in the prestigious Journal of Finance. Entitled "The Level and Persistence of Growth Rates," it was written by three finance professors: Josef Lakonishok and Louis K. C. Chan, both of the University of Illinois at Urbana-Champaign, and Jason Karceski of the University of Florida.
The professors studied the earnings-growth rates of U.S. publicly traded companies between 1952 and 1997. One of the things they were looking for were companies whose earnings grew for five years straight at more than the median rate. That's not asking much, since that median was around 10% per year "” far lower than the 62% to 112% growth rates that appear in the above table.
Yet the professors found very few companies that were able to ever meet this modest precondition. This was true even among tech companies, furthermore.
To be sure, there have been companies that have beaten these odds. The most celebrated example of recent memory is Google /quotes/comstock/15*!goog/quotes/nls/goog GOOG +0.30% , of course.
But, given the sky-high growth rates necessary to support LinkedIn's current price, along with the professors' research, Google's experience is very much the exception that proves the rule.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now.
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