In search of the next $500 stock

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Apple was one, but may never be again. Google was, then wasn't, and is again, easily.

What are we talking about? Tech stocks that reach the rarefied air of $500 (U.S.) per share. Don't be surprised if in the near future we add both Amazon.com Inc. and LinkedIn Corp. to that list.

Each stock is currently trading near all-time highs, and at nosebleed valuations. Amazon spent much of this week above $270 per share, near its January high of just over $284. On a forward basis, its price-to-earnings ratio is roughly 160, according to Standard & Poor's Capital IQ.

LinkedIn Corp. has been on a tear, up nearly 60 per cent to more than $180, giving it a forward P/E of more than 130.

The companies have something else in common: Each is spending heavily to build its future business, damaging its profitability in the near term and creating those absurd multiples.

Looking out several years, aggressive but entirely possible forecasts of the companies' revenue and operating margins suggest today's earnings are just a fraction of what is to come. That, in turn, makes today's share prices understandable – and perhaps even reasonable.

Of the two, Amazon is the more established case of a hyper-growth, highly valued company. After all, it's no startup, having been around since the 1990s (and already left for dead, once, by many investors).

Revenue of $61-billion in 2012 was 27-per-cent above prior-year levels and triple 2008's figure. At the same time, however, operating profit of just $676-million represented a razor-thin margin of just over 1 per cent.

"Investors today, for better or for worse, are not focusing on valuation," says Tom Forte, an analyst with Telsey Group. "They're recognizing the potential and actual disruption Amazon is causing in the retail space, and they're very excited about the opportunity these investments present."

The company is in what Mr. Forte calls "a hyper-stage of investment." It opened 20 fulfilment centres last year, bringing to 89 the locations it now mails goods from. In addition, it keeps rolling out variations of its Kindle e-reader; it needs more servers for its cloud-computing Amazon Web Services business; it's paying more for content to stream to its customers.

There are signs, however, that much of this is already paying off. Growth in Amazon's shipping costs, a metric that had worried many, slowed down in 2012 thanks to the new fulfilment centres. North American operating margin hit 5 per cent in the fourth quarter, a number that impressed many analysts who are bearish on the stock, Mr. Forte says. (He has a 12-month price target of $370 a share, and says Amazon is his firm's top pick in the Internet space.)

John Blackledge and Thomas Champion of Cowen & Co. believe Amazon's increasing share of online commerce, its growing cloud business, and the potential for international growth suggest the company can increase revenue by nearly 23 per cent annually through 2018 – resulting in $201-billion in sales.

At the same time, expansion in margins to the high single digits suggests profit of more than $13-billion – and earnings per share of more than $27 five years from now. A $500 share price is about 18 times that level of earnings – not 160 times.

LinkedIn is a much newer business with a shorter track record of success. Like other social networks, however, it can produce eye-popping margins, under the right conditions, that are not available to Amazon and other sellers of physical goods.

LinkedIn has been approximately doubling its revenues in each of the last five years. In 2012, it recorded $972-billion in sales with a gross profit margin of an amazing 87 per cent.

Little of that made it to the bottom line, however, as it spent hundreds of millions of dollars in marketing and research and development expenses and produced an operating margin under 6 per cent.

The company's goal is to add members, and then add products that make it easier to turn those members into money. So far, LinkedIn has shown its vast international member database is more valuable than thought by many initial skeptics, who saw a much lower level of user engagement than at Facebook.

"LinkedIn is good for members, good for companies, good for recruiters, and good for advertisers," says Trip Chowdhry, managing director of equity research for Global Equities Research. "From a long-term perspective, this company will do exceptionally well because they are meeting and exceeding every stakeholder's needs." (He is reevaluating his $150 price target because LinkedIn has now blown right by it.)

The analysts at Cowen & Co. estimate that LinkedIn can achieve $5-billion in revenue by 2018 and profit of $647-million, which works out to about $5 of earnings per share. At that point the company will still be growing at nearly 20 per cent a year and operating margins will be rising past 21 per cent.

Leading Internet names like Facebook and Google have operating margins north of 30 per cent on gross margins that are 10 to 20 percentage points lower than LinkedIn's. This suggests LinkedIn's "mature" operating margin could top 40 per cent and even approach 50 per cent.

Apply that to $5-billion in revenue, and more than $1.6-billion flows to the bottom line, resulting in roughly $16 per share in profit. A $500 price is a little over 30 times that level of EPS. (The company reported just 20 cents EPS in 2012.)

These projections are not slam dunks, by any means, as there's the prospect that each company will continue to spend for the future rather than expanding their margins.

Mr. Forte says there's a risk Amazon will keep investing in low-margin hardware, like a smartphone, or engage in an expensive content-acquisition battle with Netflix.

And Mr. Chowdhry believes LinkedIn will have to keep its spending elevated for the next eight years as it goes global. "LinkedIn should not be thinking of improving margins yet; they should be in the land-grab phase, capturing one country after another. There are 129 countries; they have a solid presence in just 20."

A hiccup along the way could throw either company seriously off the high-level growth trajectory that today's share prices imply.

LinkedIn, says analyst Michael Pachter of Wedbush Securities, simply may not achieve the member gains and revenue growth many expect. He sees the company peaking at $3-billion in revenue and not much more than $1-billion in profit.

"It's a truly impressive company. I have no problem with any part of their business, their model, how they're executing. My only problem is valuation."

Indeed, it's an obstacle for any value-conscious investor. But if Amazon and LinkedIn keep clearing their high hurdles, shareholders will look back at today's prices and see cheap stocks.

Special to The Globe and Mail