Buy Facebook and Short LinkedIn

5/3/13

Today I want to talk about a compelling pairs trade. And it includes two of the hottest names in the internet space.

LinkedIn (Symbol: LNKD) has been one of the most profitable IPO’s of the past couple of years. It’s up more than 300% from its original IPO price of $45 and is up 65% year-to-date.

Facebook (Symbol: FB) on the other hand, hasn’t fared quite as well. After opening with a bang last year, the stock was quickly cut in half. For shareholders, it’s gone from a scary ride to relatively boring one.

Now, first let’s talk about the LinkedIn side of this trade. The amazing thing about LinkedIn’s performance is its valuation. The company is obnoxiously expensive. It currently sells for a mere 1,287 times earnings – that’s a P/E ratio of 1,287. Each dollar of sales for the company is valued at $22.62 by the public market. And its price-to-cash flow is a whopping 160 (no decimal place there).

These are some of the highest multiples I have ever seen. But as you can see investors have completely ignored it.

Now, the only reason LinkedIn is gone up more than 300% since its IPO, and amassed a $20 billion market cap, is due to its massive membership base. LinkedIn has more than 220 million members. And this number has been growing steadily every quarter. With that, the market is valuing each member on LinkedIn at about a $90 per member (220 million X $90 = $19.8 Billion).

But here’s the thing. Less than 2% of LinkedIn’s members ever buy anything!

So in that respect, LinkedIn is not any different than Facebook.

But, let’s consider how the market is valuing the Facebook following …

Facebook has 1.1 billon members and currently has a $67 Billion dollar market cap. So that values each member at about $61.

So let’s recap: LinkedIn members are being valued at $90. Facebook members are being valued at $61.

I’m willing to bet this gap will narrow. In both cases, these companies are showing little aptitude toward monetizing their audience. Yet their followers are being valued at wildly differently levels.

So the best way to take advantage of this valuation gap is pairs trade. A pairs trade is market neutral trade, where you buy one stock and at the same sell short another stock in the same sector (same dollar amounts).

Since they operate in a very similar business environment, there should be little market risk associated with this trade. I win if this valuation gap narrows. I lose it if it widens. I like my chances.

Will Meade

Editor of the Billionaires Portfolio