How to value loss-making companies

By | CYH

Many young, fast-growing companies have managed to list on the stock market in recent years. What used to be exclusive to venture capitalists have now been tradable by retail investors.

But investors are not used to analyzing such companies – they are making losses and popular price metrics like PE ratio are unusable.

I would even say that any price-based metric would be less useful as loss-making companies often hold a large cash pile after rounds of fund raising.

This cash pile is worth something and price-based metrics only consider market capitalization without the cash.

Enterprise Value would be a better measurement as it is calculated by deducting cash from the market capitalization and adding any debt the company owe.

Debt is often non-existent in loss-making companies because no bank would want to lend them – business metrics are bad and there are no worthy assets as collaterals. Hence, these companies go for equity funding instead.

Next we can find a suitable denominator to pair with Enterprise Value. Revenue would be an obvious choice since it could be the only positive number in the income statement for loss-making companies.

But historical revenue isn’t helpful as market appraise such companies based on their future growth. Forward revenue is more relevant.

The forward revenue could be derived from management’s guidance or by analysts’ consensus.

The final metric looks like this: Enterprise Value / Forward Revenue

The lower the metric, the cheaper the stock is.

If the cash level is high, the Enterprise Value will decline, lowering the metric.

If the growth is high, the denominator would be larger and lowers the metric too.

The final step is to do a relative comparison of this metric against the rest of the peers in the same industry. This would give you a good sense which are the cheaper ones.

The downside of relative valuation is that a scenario of ‘retreating tide lowers all boats’ could happen. Like now – interest rates are going up and that lowers the future value of these companies as a whole.

Even if you buy a cheapest stock in the sector the price can still go lower in such a situation. But not a big problem if you intend to hold long term and dollar cost average periodically as the tide would eventually return.

That said, valuation is just one part of the due diligence. Qualitative analysis needs to be done too – assessing the competitive landscape and determining the strongest player that could eventually capture most of the market share. If it doesn’t, it is not worth buying even if it is the cheapest stock.

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