Will Accelerated Growth Lead to Large Gains?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

LinkedIn (NYSE: LNKD) and Zillow (NASDAQ: Z) have been industry favorites in the Internet space since Facebook’s (NASDAQ: FB) IPO debacle.

As of July 24, Facebook had lost 30% of its value since becoming a public company. During that same period, LinkedIn and Zillow have both doubled. However, after Facebook’s quarterly results, it could now follow their lead.

The Gold Standard

Internet-based companies are valued on two metrics: Growth and potential. If a company has rapid growth and the market believes that growth is sustainable, then a company can trade well above its fundamentals. Such is the case for both Zillow and LinkedIn.

Zillow is an online real estate marketplace and earns its money through agent subscriptions and advertising. During their last quarter, revenue grew 70% year-over-year. Zillow has reported sales of $132 million over the last 12 months and has an operating margin of 1.1%.

LinkedIn is a social media company that focuses on career networking and jobs. The company makes its money through user subscriptions, advertising, and a number of new services. LinkedIn grew its Q1 revenue by 72% year-over-year and has operating margins of 6.3%.

Both LinkedIn and Zillow trade at 19 times annual sales, which judging by the performance of both stocks, seems to be the gold standard of valuing an Internet company.

Natural Growth

Theoretically, as a company grows larger its year-over-year revenue growth will slow. In biotechnology, a product has peak sales estimates, and a company is valued according to potential sales. This is no different for Internet companies, as investors must determine the fundamental upside for a job-based company (LinkedIn), a real estate marketplace (Zillow), or any other company when determining fair value.

LinkedIn validates the natural revenue slowdown that occurs with growth, as its last four quarters of year-over-year growth have been as follows:

Q2 2012

89%

Q3 2012

81%

Q4 2012

82%

Q1 2013

72%

The above chart shows that LinkedIn’s year-over-year growth is in fact decelerating as the company grows larger. However, LinkedIn maintains its 19 times sales valuation, showing that it’s still the preferred Internet company among investors.

A New Market Favorite?

As of Wednesday, Facebook traded at 11.5 times sales. However, the stock traded higher by nearly 20% in the after hours following its Q2 report.

In the quarter, Facebook’s revenue increased 51% year-over-year to $1.81 billion. Therefore, Facebook’s after-hour gains combined with its revenue gains would give the stock a price/sales ratio of 12.25, significantly greater than its closing ratio on Wednesday. Here’s why.

Quarter

Year-over-year revenue growth

Q2 2012

32%

Q3 2012

32%

Q4 2012

40%

Q1 2013

38%

Q2 2013

51%

Clearly, Facebook’s growth is accelerating as it becomes a larger company, which is very unusual. Facebook has revenue over $6.1 billion for the last 12 months. LinkedIn is significantly smaller with revenue of just $1.1 billion during the same period.

Facebook has 1.155 billion users, which is 45 million users higher quarter-over-quarter. LinkedIn grew its users by just seven million in the same period, totaling 225 million users. Thus, Facebook has more users to monetize, and has not bogged itself down to any one industry. Moreover, Facebook earns revenue from advertising, but also royalties from Facebook game developers, royalties from Facebook vendors, and revenue from promoted posts among many other sources.

The end result is that Facebook’s outlook is appearing quite enticing for investors. By Internet company standards, the stock is fairly cheap, and its accelerated growth could push it higher to the upper echelon of Internet company metrics.

The big concern with Facebook following its IPO was whether they could monetize mobile. In this last quarter, mobile use jumped 51% over last year, and mobile represented 41% of total advertising revenue for the second quarter. As a result, it looks like those concerns of mobile monetization are no longer relevant.

Therefore, Facebook deserves your attention, as this last quarter could be a perception changer, and a value creator. And in this particular space, there is a lot of room for Facebook to trade higher.

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Brian Nichols is long Facebook. The Motley Fool recommends Facebook, LinkedIn, and Zillow. The Motley Fool owns shares of Facebook, LinkedIn, and Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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