The question has come up about whether or not Microsoft (MSFT) has overpaid for LinkedIn (LNKD). We’re going to apply Dow Theory to determine what would have been considered the fair value for LNKD based on the stock price. Next, we're going to see how much or how little MSFT paid for LNKD.
First, we need to establish what Dow Theory considers the fair value. According to S.A. Nelson, fair value is determined when…
"...stocks have recovered after artificial depression and relapsed after artificial advances to the middle point which represented value as it was understood by those who bought or held as investors."
The idea of “…bought or held as investors…” is very important as it reflects individual (or institutional) money that has decided to buy a stock with the expectation of holding for an extended period of time, usually 5 years or more.
Artificial Advance and Depression
When looking at the price movement of LinkedIn, it is easy to identify the artificial advances and depressions. However, to determine the fair value, a price which long-term holders of the stock have, on average, acquired the stock, we look to the middle point.
In order to determine the middle point (fair value), based on Dow Theory, we look at the previous major advance from the low to the high in the stock price. The previous low was $59.07 and the previous high was $276.18. The middle point (also know as the 50% principle) is $167.63.
LinkedIn Fair Value
If fair value for LinkedIn was actually $167.63 and Microsoft agrees to pay $196 per share, that would suggest a premium of 16.92%. How does this crude methodology stack up against institutional analyst assessments of fair value for LNKD? This from Morningstar.com:
“LinkedIn posted a better-than-expected start to 2016 as the firm beat both consensus estimates and management guidance for revenue and EBITDA, with strong performance across all three segments. We reaffirm the company's wide moat rating and our fair value estimate of $155. With shares trading just inside three-star territory in after-market trading, we would wait for a larger margin of safety before investing (source: Macker, Neil. “LinkedIn Starts 2016 By Beating Expectations, Management Remains Focused on Engagement”. Morningstar.com. 4/29/2016. accessed 6/14/2016.).”
Morningstar had $155 while Dow Theory assessed a $167.63 fair value. Although the Dow Theory method seems arbitrary, it is based in sound reasoning which we have covered before on the topic of the 50% Principle.
So, the question becomes not “did Microsoft overpay for LinkedIn?” instead it should be viewed by “how much did Microsoft overpay for LinkedIn?”. Based on Dow Theory, Microsoft didn’t pay much more than the company would have been worth to long term holders of the stock, in this case a premium of only 16.92%.