Don’t Always Fear Sky-High P/E’s

For hyper-growth companies, sometimes it's more about revenues

   

Professional social media stock LinkedIn (NYSE:LNKD) has made a breathtaking 90% run this year. But the problem with those sort of returns — a bubbly valuation.

In LinkedIn’s case, it couldn’t be more bubbly. LNKD’s price-to-earnings ratio is floating around the upper 900s.

You read that right. A nine followed by two zeroes. Or today, a nine followed by a seven and a four.

So why aren’t investors worried? Well, price-to-earnings, while an important indicator of a company’s value, is far from a perfect metric.

One key problem is that it looks to a company’s earnings for the past 12 months. But considering how investors usually are more interested in how the company will do — rather than what it has done — a forward P/E can be a much better metric. Forward P/E uses the earnings a company is expected to earn (admittedly, also not perfect) for the next 12 months, which can help rationalize the numbers.

Of course, even then, you still might be facing some pretty unreasonable numbers. LinkedIn’s forward P/E is 91. It’s not 900, but it’s still a scarily high number.

So why would investors be willing to keep buying a stock with such lofty valuations? Because many investors are interested in the company tale told through revenue growth, not profits. ServiceNow (NYSE:NOW) CEO Frank Slootman recently told me in an interview: “If a company is growing quickly and there is a profit, then the CEO is probably doing something wrong. You want the focus to be on growth — and speed is critical.”

As should be no surprise, the IPO market is a breeding ground for hyper-growth companies whose P/E’s and even forward P/E’s are so bloated, they could scare investors off — even though the companies themselves are perfectly healthy and properly growing. Here’s a look:

Palo Alto Networks

Forward P/E: 158

All you need to do is look at some of the high-profile cyber break-ins at LinkedIn, Sony (NYSE:SNE), Yahoo! (NASDAQ:YHOO), Visa (NYSE:V), MasterCard (NYSE:MA) and others to know the online security industry has some major growth drivers. A big problem is the “consumerization of IT,” which includes the heavy use of mobile devices, the cloud and Internet apps within the workplace.

To fend off threats, companies have little choice but to purchase expensive security software. One of the beneficiaries is Palo Alto Networks (NYSE:PANW). Its technology helps to provide real-time security but without the degradation of the performance of IT networks.

No doubt, Palo Alto’s growth has been substantial. In the latest quarter, revenues spiked by 88% to $75.6 million and the company added more than 1,000 customers. As for the past year, revenues have surged by 115% to $255.1 million; sales for 2010 and 2011 were $48.8 million and $118.6 million, respectively.

The revenue ramp will slow down somewhat, but should remain torrid overall. Based on the Wall Street consensus, PANW should see a 50% increase for the next 12 months.

Yelp

Forward P/E: 519

The local business market is massive, and Yelp (NYSE:YELP) has been able to get a piece of the action. It has created a trusted platform where customers can review restaurants and other local businesses.

A big growth driver has been mobile. Yelp has the No. 1 travel app and gets about 7 million unique mobile users per month. The company’s CEO and co-founder, Jeremy Stoppleman, recently mentioned that it has been effectively monetizing its mobile traffic. Then again, the ads are “unobtrusive to the user.”

For 2012, Yelp projects revenues to grow at a rate of 62% to 63%, coming to $135 million to $136 million. But the growth still looks to be in the early stages. Yelp has been highly disciplined in how it enters a new city, with a focus on building a strong presence that creates customer loyalty.

The company currently has 790,000 local merchant customers in the U.S., Canada and Europe, but the ceiling is much higher, as the total number of businesses in these markets is more than 50 million.

ServiceNow

Forward P/E: 3,446

ServiceNow leverages cloud technology to help automate IT functions like workflow, notifications, reporting and software upgrades. The company’s platform is low-cost, requires little consulting help and has a unique system to create custom apps.

It helps that ServiceNow is fighting against incumbent operators that have failed to innovate. These companies include players like BMC Software (NASDAQ:BMC), CA (NASDAQ:CA) and Hewlett-Packard (NYSE:HPQ).

For 2012, ServiceNow predicts that revenues will grow at a range of 82% to 85%, which translates into revenues of $233 million to $237 million. And these revenues are understated because ServiceNow charges customers subscriptions. According to accounting rules, the company cannot recognize prepaid revenues, which tend to be large for enterprise software operators like ServiceNow.

Tom Taulli runs the InvestorPlace blog IPOPlaybook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “All About Short Selling” and “All About Commodities.” Follow him on Twitter at @ttaulli. As of this writing, he did not own a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/ipo-playbook/dont-always-fear-sky-high-pes/.

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