Expensive or Worth It?

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

The current industry price to earnings average for the technology sector is 22.50. (as of 1-22-13)  This got me thinking: what companies trade for more than double the industry average?  More importantly, which of these high valuation companies are truly worth the price?

I came up with several prospects, but I've picked out five companies for us to look at.

  1. Linkedin (NYSE: LNKD)
  2. Facebook (NASDAQ: FB)
  3. Applied Materials (NASDAQ: AMAT)
  4. Rackspace (NYSE: RAX)
  5. Equinix (NASDAQ: EQIX)

Before we get to talking about these companies, let's get an overview of how these companies stack up in some basic metrics.

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Market Cap</strong></td> <td><strong>Price to Earnings</strong></td> <td><strong>Forward P/E</strong></td> <td><strong>Profit Margin</strong></td> <td><strong>Dividend/Yield</strong></td> </tr> <tr> <td>Linkedin</td> <td>$12.82 Billion</td> <td>769.61</td> <td>92.47</td> <td>2.04%</td> <td>n/a</td> </tr> <tr> <td>Facebook</td> <td>$66.57 Billion</td> <td>159.22</td> <td>46.56</td> <td>6.28%</td> <td>n/a</td> </tr> <tr> <td>Applied Materials</td> <td>$15.22 Billion</td> <td>147.79</td> <td>13.38</td> <td>1.25%</td> <td>$0.36/2.8%</td> </tr> <tr> <td>Rackspace</td> <td>$10.48 Billion</td> <td>106.33</td> <td>71.55</td> <td>8.11%</td> <td>n/a</td> </tr> <tr> <td>Equinix</td> <td>$10.75 Billion</td> <td>90.92</td> <td>67.98</td> <td>6.36%</td> <td>n/a</td> </tr> </tbody> </table>

The trends

As we look at the trends for these companies, some interesting things begin to emerge.

<img src="http://media.ycharts.com/charts/72c833f595f9b4b82545d1207a008058.png" />

LNKD Revenue TTM data by YCharts

<img src="http://media.ycharts.com/charts/cfece71ea6acf952c28f956518994b69.png" />

LNKD Net Income TTM data by YCharts

LinkedIn and Facebook grew their revenue faster than the other three companies that we are looking at. Revenue is a good thing to grow obviously, but interestingly enough, more revenue hasn't directly translated to net income.  LinkedIn's revenue has increased over 240% over the last 2 years, but net income is only up 58%.  Facebook's revenue is up 134%, yet their net income is down over 60%.

Meanwhile, Rackspace and Equinix saw their revenue grow over 50% over the same span of time.  Yet Rackspace's net income is up over 100% and Equinix's net income is up over 200%.

Applied Materials has been trending downwards in terms of both revenue and net income.

Cloud guys 

Rackspace is a company poised to take advantage of the growing cloud market.  Equinix also has significant interest in how the cloud market does.  This is kind of a buzz industry right now creating a lot of excitement among investors.  The high valuation comes from high expectations that this market will continue to grow at a fantastic rate.  And indeed the charts show that this really is a money maker.

Rackspace has been able to generate a good amount in free cash flow over the last couple years.  As fool Seth Jayson points out, this company is doing great when it comes to their money.  But while things are going great with earnings and cash flow, these things simply must continue to justify the valuation.  Fool Sean Williams questions whether the growth is going to continue at the current rate.  He pointed out that Rackspace's customer base only grew 3.5% last quarter.  If the market sniffs a slowdown, this valuation will come down.

Equinix has a high valuation not just because of their position in a growth industry, but also because investors are excited about this stock becoming a REIT.  This is the cause of the current P/E ratio around 90.  Can this valuation hold up?  Perhaps.  Can this stock continue to go up?  Again, fool Sean Williams believes that the upside is indeed priced into this stock.  Of the five companies we are looking at, this one's price to earnings ratio is set to drop the least.  

So, are these two companies expensive or worth the price?  My takeaway with Rackspace is that it is a great company worth owning at a lower price.  Equinix is priced a little high for me.  With the industry average price to earnings for retail REITs at 68.8, I think that some better deals can be found than this one.

Chips

Applied Materials is a semi-conductor play.  When you look at the financial metrics of this company, things don't look too bad.  The valuation thing is temporary with the company trading at just 13 times next year's earnings. Dividends are stable and in the good habit of rising.  For investors who like share buybacks, you're happy about the $3 billion in buybacks this company has approved.  Indeed, many would see this as a good value.

This company doesn't offer big growth.  As the chart above shows, revenue has been on the decline. Expensive or worth the price?  I'd say it's worth the price.  But I don't think this is our best opportunity of these companies we're looking at.

The social networks

Finally we end up with the social networks LinkedIn and Facebook.  

LinkedIn is a company a lot of people love.  They have a growing user base.  The revenue for this company is in the form of subscriptions which means that revenue is recurring.  The seem to have some smart guys at the top.  This company's valuation is also set to drop the most of these five companies.  Dropping from near 800 to under 100 signals huge growth is going on.  I've always praised LinkedIn, the business.

Facebook has been growing profits at what I would call a modest rate given the valuation.  But I recently outlined some new initiatives on the horizon that could boost Facebook's income.  When you are dealing with a website that caters to 1/7 of the population of planet Earth, any little thing you do for revenue can trickle down into big profits.  

Most recently, people are talking about Graph Search.  Investors weren't impressed when this thing was first announced.  That's understandable since there is no money aspect tied to this yet.  But Graph Search is extremely impressive in its capability.  It's important to note that at one time Yahoo! was the king of search engines.  Then Google came in and innovated a far superior search engine that worked completely differently than Yahoo's.  Graph Search is the next major innovation.  I don't think it's a Google killer, but it represents Facebook going toe-to-toe with the best in the search business.  But just because Graph Search isn't a new revenue source yet, it can very possibly turn into one.

When it comes to Facebook, I say that they are worth their price.

Conclusion

Like I said in the article, I think LinkedIn is a good business.  I also think that Rackspace is a good investment at a cheaper price.  If I had to pick which of these companies I like best at their current prices, I'd have to go with Facebook.  I haven't always been a Facebook fan, but I have become more impressed with the evolution of this company with each quarter.  To me, this is the best value here.


thequast has no position in any stocks mentioned. The Motley Fool recommends Facebook, LinkedIn, and Rackspace Hosting. The Motley Fool owns shares of Facebook and LinkedIn. 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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