UK Individual Shareholders Society

ShareSoc

Home

UNPROFITABLE COMPANIES  

VALUING UNPROFITABLE COMPANIES AND COMPANIES NOT VALUED ON PROFITS

If you don’t know where to begin, you could call us for some general advice.

ShareSoc can provide some general advice for new investors (but not specific advice on what shares to buy or sell). Go to the Contact page to contact us.

This page is based on articles written by Roger Lawson and first published in the ShareSoc Informer newsletter in June 2011.


I have covered the subject of “What Makes a Good Company” in a previous article. There were two aspects of this that were beyond the scope of that article which was primarily about judging the quality of a company in terms of its attributes, structure and management. The two aspects that were not covered were:


- Valuing the company and ensuring that you only pay a reasonable price for the shares. It is obvious that even great companies can sometimes be over-priced so the key is to buy good companies at reasonable prices. I will try to cover the financial analysis of companies and the common ways to determine a fair price in a future article.


- The other obvious omission was that I said that one golden rule was only to invest in “profitable companies”.


This might certainly be a good rule to follow for new investors who are inexperienced in financial and business analysis. But there are a few situations where it might be worth making an exception. These are:


Asset Rich Businesses

There are obviously some companies that have no profits, or even some losses, where the value of the assets is such that it can surely be judged to be worth more than nothing.


The extreme example is that of a “cash shell”, which can be defined as a company with no operating businesses, no assets other than cash on the balance sheet, no significant liabilities and minimal administrative overheads. In that case, the directors can either return the cash to shareholders or buy a new profit generating business with it.


Oh but it was that simple! Often such companies are valued at significantly less than the cash they hold because there may be unknown liabilities, unreasonable delays in returning the cash, directors who would prefer to get paid large fees rather than wind-up the company, and numerous other risks not immediately obvious to shareholders.


At the other extreme, cash shells can sometimes be worth more than the cash they hold if the management seem to have experience and a clear project where the  money will be invested. But this is where faith in the management can often be excessive.


A more common situation is where a company has been reporting losses for several years, and indeed may have been “cash negative”. Often they might still have been paying dividends, but could have been selling assets to raise cash. Again it would be wrong to suggest these companies are necessarily worthless.

But the key question is: does the realisable value of the remaining assets exceed the market cap of the company so far as a trade buyer is concerned? Or alternatively, can the business be turned around to profitability in the near future?


Taking the first of those questions, looking at the balance sheet does not necessarily answer it immediately. In theory you can simply look at the “Net Assets” which hopefully some accountants have valued on a conservative and conventional basis. But there are numerous problems with this. First there may be lots of goodwill or other intangible assets in there that may be either worth a great deal, or worth very little. Indeed there may be goodwill such as trade marks, patents and other intellectual property which are not even properly valued in there at all.


On the other hand, in a retail company for example there may be lots of “fixtures and fittings” that may be worth something to the company but not to anyone else.


A company which is consistently “cash negative” will sooner or later go bust, and the longer such a business can continue, the more the assets are depleted. So the “cash burn” rate of unprofitable companies is often examined simply to see how long they can survive.


But such companies are in essence “duds” that can only be seen as “suitable cases for treatment” to paraphrase the title of a 1960s film, i.e. cases for “restructuring” or even “asset stripping” in the Gordon Gecko style to realise value.


Valuing such businesses really means you have to understand the industry in which it operates and look at it like a trade buyer operating in that sector would do. But if you hold out in the expectation of bids from trade buyers or asset strippers, you may wait a long time as typically they will only want to pay “fire sale” prices.


Businesses with Prospects

Another kind of business that may be worth a great deal despite having no profits, or even reporting losses, are those with assets that might not be generating profits now, but will do so in the future.


In that case the assets may not be valued by the market in the same way as the accountants have valued them in the balance sheet.


A good example is an oil exploration company which may simply have rights to exploit a particular area. The reserves of oil in that area may be very uncertain—they may be nothing, or they may be very large. Until some wells are drilled there is no certainty whatsoever. And until oil has been discovered and production commenced, which may be some years hence, there will be no cash profits generated.


The best way to evaluate these kind of companies is to do it in the same way as one looks at any risky large capital intensive project. This is best done with a discounted cash flow (DCF) model where you put in all the cash movements (from up front investment to eventual returns, weight them based on likely probabilities, and “discount” the future cash flows to reflect the time value of money. In essence cash received in the future is worth less than cash received tomorrow.


A full explanation of how to construct such models is beyond the scope of this article but it is not difficult to find good texts on the subject. Of course, building an accurate such model is plagued with problems of uncertainty and it does require you to know a great deal about the industry and the actual operating characteristics of the company being studied (preferably more than they publicly have to disclose). This is why bulletin boards are populated by folks discussing oil exploration companies, their latest forecasts of reserves and the results from individual well drilling. Short cuts to valuations based on qualification of reserves are often used to simplify matters (as are P/E and PEG ratios for other companies).


Technology Businesses

Apart from oil and mineral exploration companies, another kind of company that can be valued depending on future prospects is the “coming technology” vendor.


These are companies that have some ground-breaking technology, that may not yet work, but is expected to have a massive market potential some time in the future.


These could be software or hardware companies with new inventions, where market acceptance or roll-out could take some years. Or another example would be a pharmaceutical company who have just developed a cure for cancer—it just needs to go through some clinical trials and get regulatory approval. But anyone who has invested in pharmaceutical companies will realise what a nightmare that simple statement can imply!


In the technology sector, there may even be companies who seem to have great opportunities in the future but no obvious “business model” to enable them to generate revenue and profits. For example companies such as Facebook had difficulties “monetizing” their customer base initially but look like they are doing so now from advertising primarily.


But there have been many technology companies who claimed millions of customers that they could not turn into profits—for example, ISPs who were offering email accounts, or web site owners whose sites were valued on “visitors” but no obvious way of converting them into paying customers. So be wary of people who talk about “alternative valuation” models when looking at these kind of businesses. What matters is whether they do, or will, generate cash!


Companies Not Valued on Profits

The article above assumes that companies are valued by the market primarily on their reported profits (which is a proxy for future positive cash flow). But there are some companies which seem to be valued in different ways. Examples are property and insurance companies which are likely to be priced on the basis of their net assets. In the former case, clearly the value of properties held is of major significance (and may be easily realisable, unlike the assets on many balance sheets). In the latter case, insurance companies often generate a significant proportion of their profits not from their operating activities but from the returns on the investments they hold against future liabilities. Operating profits may also be very volatile depending on claims experience while investment profits are less so (and the investment holdings are again easily realisable into cash). But this view by the market does tend to create some anomalies.


One sector that seems to have a specific “rule of thumb” approach is the IT sector, and particularly software companies.


These are often businesses that are growing revenue rapidly but have little or no profits. Indeed if they manage to generate any profits, they might simply expand their sales and marketing operations, or invest more in product development because the managers of these companies often perceive that as the best use of funds. So they don’t pay out dividends to shareholders, or necessarily pay themselves a great deal in salaries either.


Being software companies, they probably don’t capitalise a lot of their development costs, and they certainly don’t normally have much else in the way of assets, so valuing these companies on the basis of assets would also not give a very realistic figure.


So how do you or trade buyers of these businesses value them? The general rule goes something like this:


- One or two times revenue for moderate growth companies.


- Three or four times revenue for high growth companies.


- Up to ten times revenue for really high growth companies.


Where a company falls on this spectrum also depends on not just the historic or likely future growth in revenue, but whether they are operating in “hot” sectors, i.e. those where buyers might be looking to enter the market by acquiring such businesses.


Valuing Facebook

So those operating in the Social Networking arena such as Facebook and LinkedIn can be valued even higher than a multiple of 10 times revenue, although some commentators have suggested that valuations in this area are moving into “bubble” territory. For example, a recent auction of Facebook stock (still unquoted) valued the company at $84 billion—and just to remind you of normal reality, Tesco is valued by the market at about $50 billion. But Tesco has sales of about $70bn while Facebook has forecast (not historic) revenue of $4bn for the current year. So Facebook is valued at over 20 times forecast revenue.


Margins are Not the Same

Retailers are of course quite often valued at relatively low multiples of revenue and Tesco is no exception in that regard. Their margins are of course usually pretty small in comparison with other types of businesses, and food retailers are particularly small. Software companies often claim gross margins of over 90% with relatively fixed overheads so in theory (and management will often remind you of this), if the sales expand the profits can grow at a very fast rate. But in reality, it’s normally not quite as simple as that as usually a larger sales operation requires a larger management infrastructure, a bigger support operation, more marketing expenditure to achieve the higher sales and other cost increases.


Why Do These Valuations Apply?

Obviously in the case of companies like Facebook there is a good deal of “hope” in the valuation. It is expected that this company will soon become, if it is not already, the “gorilla” in the market space for social networking applications.


In the same way as Google has become the dominant player in the “search” field, or Microsoft for PC operating systems, it is therefore expected that such a business will be able to generate superior profits and returns on capital going forward, and effectively establish a market monopoly.


But why would smaller companies with more limited growth prospects and no clear ability to achieve world domination get similar valuations when the profits do not obviously justify them?


Trade Buyers Set the Valuations

The reason for the valuations of these kind of companies is because potential trade buyers set the valuations. A small software company may have some special intellectual property that a trade buyer could find essential within its own products to take a leap forward technically, or which can enable it to expand its own sales operations significantly.


Also the acquirer might well have a much larger distribution and sales network, so it can take the products of the smaller company and easily increase the sales many fold. Another reason it might make sense is that often a small company has disproportionate central overheads, so when they are part of a larger organisation these costs can be stripped out and what might have been a barely profitable company is instantly rejuvenated. Just removing surplus directors can save a considerable sum.


These high valuations depend on not having excessive losses, and continuing high growth. If a company goes “ex-growth” for any reason, the multiples can fall rapidly and the share price effectively collapse, so this is one thing to be very wary of—you need to keep a close eye on revenue trends.


Valuing Companies with No Revenue

The above discussion is based on the fact that valuation on revenue multipliers is used because it is the most relevant and the only readily available metric for such companies. What to do about companies with little or no revenue?. Here you are into crystal ball gazing to a large extent, although the historic investment in R&D can provide perhaps a baseline valuation, or comparing it to similar companies that are further ahead in their business development is a good approach.



GETTING STARTED?

Did you find this information useful? If so why not join ShareSoc and help to support our activities? Go here for more formation: Membership