It is much easier to value a profitable company than an unprofitable one. Generally a company’s profit is its value to the shareholders. Of course, you could look at assets of a company in relation to its market cap. If assets are bigger, the company may be undervalued.
Ok, so if profit is generally the value of a company, why would you even buy an unprofitable one (other than for its assets)? Here’s why: once a company is recognized as a star by the market, it is often too late to get in at a good price. For instance, many technology companies start out with pretty good stock prices and shoot up once they are on the verge of profitability. Buying one early is often a good idea.
But buying a tech company young just because its a tech company is not a good idea. Because it still has to be a good company.
Let’s talk about an unprofitable company for a minute. Say you are hired as CEO of Acme Tech, Inc and it is unprofitable. What do you do to change that?
Cut Expenses
Probably the easiest way to get rid of the red ink is to cut expenses. This will only take us so far though. The company often has contractual obligations such as a building lease, employee payrolls, unions, etc that limit the options to cut expenses. You can only do so much, but still this is an option.
Improve Sales Efficiency
A low-cost way to increase revenues is by improving sales efficiency. This could involve marketing research or reverting to commission only sales. Somehow, someway, get more sales with the same number of people.
Beef Up Sales Staff
At this point we are getting into investing for growth. Adding sales staff makes sense as long as the return on the investment makes sense.
Note that when we are investing for growth, money has to come from some place. Either by burning cash, selling more shares, or raising money through debt issuance. If the company is losing money, that money has to come from some place too. We will talk more about this a little later.
Create An Add-On Product
We could create an additional product to sell to our existing customers. This would also be an investment, this time in Research and Development (R&D). This makes sense only if our return on investment from R&D makes sense.
Beyond R&D though, there is not a ton of money invested. We still use the same sales people, same customers. We might spend a bit more on sales commissions but that’s about it.
Buy A Smaller Company
You could grow Acme Tech, Inc via a buyout of a smaller firm. This is an investment also, and what we are looking for is synergy. Synergy means that the combined companies will either make more together or spend less, often this means both. The value of the synergy must make sense to the investment we are making.
Return on Investment
Return on investment is generally the percentage we make from an investment. For instance, if I make 20% on my $1000, that is $200 per year. That $200 per year is profit or profit difference from my investment.
Often, CEOs think that buying out other companies is a good growth strategy, but if the return on investment is not there, they are hurting their growth rate ultimately, not improving it. It is very important for management to analyze any investment before they make it, making sure they are improving the company.
Analyzing A Company Without Profit
Your job as an investor is to figure out if a company has a path to profit and what value makes sense for the share price. Often companies do start without profit, going upwards of 5 years or more until they reach profitability. Each successive year should show more revenue and stable expenses, i.e. revenue growth. Part of your job will be to determine where this revenue growth comes from. Is the company just naturally growing 25% per year in revenue? Are they taking any actions that are contributing to revenue growth?
We should also check cash, equity, and debt year over year. How is a company managing not to be profitable? Cash Burn? Selling Equity? Or Increasing Debt?
Lastly, we need to make an estimate of what the share price should be now based on what we expect future profit to be. This may be a little tricky, but doable. A good guess based on what you can figure out from the financials will be better than ignoring the issue.
Be Your Own Analyst
The wrong thing to do is to depend on others, anybody else, to tell you what companies are worth the investment. Do your own work and you will definitely come out ahead.
More Reading:
- What Does a Negative PE Ratio Mean for Stocks? – Stock Analysis
- Why Uber Stock is Worthless: Road to Zero – Wealthy Diligence
- Stock Analyst Ratings – What do they Mean? – Warrior Trading
- For Growth Stocks, Profits Are the New Normal – Alliance Bernstein
- Fundamental Vs Technical Analysis for Investing – Valuation Master Class