This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

And speaking of the worst ...
The LinkedIn (NYS: LNKD) fan club just got a little bit bigger. By my count, last week's upgrade to "buy" from Collins Stewart makes for four positive press releases on the company in as many weeks. As you may recall, the online professional network-builder received a trio of Wall Street endorsements earlier this month from its IPO underwriters -- JP Morgan, Morgan Stanley, and Bank of America. Ignoring the stock's sky-high price-to-earnings ratio, these three megabankers urged investors to buy the stock in anticipation of a doubling of earnings before interest, taxes, depreciation, and amortization (EBITDA) next year.

Why did the bankers focus on EBITDA rather than the more user-friendly P/E ratio? As I explained last time around, it's because they'd have looked pretty silly trying to justify the 872 price-to-earnings ratio that results from LinkedIn's mere $10 million in actual net profits.

Honest bankers
From a purely mercenary point of view, I kind of admire the bankers' gung-ho attitude toward their IPO baby. (At worst, you can compare them to the proverbial "honest politician" -- the one who, having once been bought, stays bought.) But this does get me to wondering: If JPMorgan, Morgan Stanley, and B of A are all singing LinkedIn's praises in part because they underwrote the IPO, then what is Collins Stewart's excuse?

I mean, they weren't part of the underwriting team. They've got no clear motivation to "pump" the stock. Yet when it comes to making dubious predictions for LinkedIn, Collins Stewart can go toe to toe with the big boys. Just listen to a few of the comments Collins put out in LinkedIn's defense yesterday:

  • It's "the only company providing passive recruiting at scale."

  • With $436 million in trailing revenues, it has less than half the sales of Monster Worldwide, but this small size just gives LinkedIn more room to grow in this $85 billion "talent-acquisition market."

  • At the same time, LinkedIn is already "15-35 times bigger than other professional networks like XING and competitive Facebook apps like BranchOut."

  • Best of all, with a share price that's been cut in half since shortly after the IPO, LinkedIn could produce 35% profits for investors if it soars to Collins Stewart's $86 per share price target over the next 12 months.

And yet, Collins Stewart also admits that at a share price "62x 2013 [pro forma] EPS," investors have "little room for error" in buying LinkedIn at today's prices. On this point, at least, I agree with the analyst. But I'd even go further, and point out that whether or not LinkedIn itself makes an "error" that hurts its business, anyone who buys the stock at today's price is certainly making a big mistake.

Now, I've spoken several times already about LinkedIn's high price, and why it makes the stock look expensive. Rather than reinvent the wheel today, let's instead focus on another aspect of LinkedIn: its growth rate.

On average, Wall Street analysts expect LinkedIn to grow at a blistering 80% annual pace for the next five years. But will LinkedIn's rivals really permit this to happen? I mean, right now, LinkedIn is the biggest dog in the park for "social recruiting." But it seems to me you don't need to tweak the business models at Facebook or Google's Google+ service very much to create a viable rival to LinkedIn... and turn the company into the MySpace of social recruiting.

Farther abroad, in high-growth BRIC markets like China and Russia, the situation's similar. Anything Google can do, Baidu can do better -- and is, with earnings poised to jump more than 90% in 2011 compared to last year, or almost four times Google's growth rate. And in Russia, new IPO Yandex is flush with investor cash, and looking for places to put it to work.

Foolish takeaway
Collins Stewart is right to point out the risk inherent in buying a triple-digit P/E stock with a double-digit growth rate. Where this analyst goes wrong, I think, is in overestimating the "room for error" that LinkedIn investors have to play with. There isn't "little" room, but none at all.

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At the time thisarticle was published Fool contributorRich Smithdoes not own shares of (or short) any stock named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 342 out of more than 180,000 members. The Motley Foolhas adisclosure policy.The Motley Fool owns shares of Google, JPMorgan Chase, and Bank of America.Motley Fool newsletter serviceshave recommended buying shares of Baidu and Google.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

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