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Valuing unprofitable businesses


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You hear many prominent investors talk about how gaap accounting doesn't really reflect the true earning power of some businesses. 

 

Many growth companies are dumping money back into SG&A or M&A etc. So it's hard to see from the income statement how much of that is required to run the business or how much is being plowed into for growth. Hard to imagine how the margins would look after the company's growth stabilizes. 

 

How would you measure return on the money the company is spending to grow when they are not profitable? 

 

I know each business is different & there isn't a one size fits all solution. 

 

I've recently read Bruce Greenwald new book on value investing & he refers to earning power valuation. I found that confusing. 

 

Many questions. Just some stuff I've been thinking about. Any thoughts would be appreciated. 

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From my hazy recollection, Greenwald suggested dividing the increase in sales by the increase in gross PP&E, right? To calculate some sort of incremental asset turnover ratio? There's an interesting idea in there to connect an output like sales or earnings to invested capital. And you could treat some SG&A as investment if you want.

 

A more general approach is just to look further up the income statement and make estimates based on industry norms. i.e. go from net income to EBIT to EBITDA to gross profit to sales to users until you find a positive number. Then work in reverse making estimates to arrive at a potential future FCF figure.

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I'll have to check again but I thought he divided SG&A & M&A in half... For his Intel example. Considered that was the cost of running the business & rest was for growth. 

 

What if the entire industry is non profitable? 

 

So you really need to understand the industry to guess the margins? 

 

Any books you would recommend? 

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I think with any company, profitable or unprofitable, you need to understand their incremental profitability of an additional customer, and try to build an estimate of long-term margins for the business. Without going into all the different parts of the income statement that might change over time, this is generally what you would need to do. 

 

Another way that is interesting is trying to reverse-engineer the current valuation. There are smart people out there willing to pay the current price for whatever company it is. What assumptions are they making, and what assumptions about future growth and margins do you need to make in order to justify the valuation? Do you think those assumptions are reasonable give the information you know about the company and industry? 

 

Your question around what if the entire industry is unprofitable is a good one, and interesting. I would be willing to bet there is some company somewhere in the world doing something similar to them that may be more mature that is actually making a profit, even if its SaaS or something "disruptive". Its possible you could miss a phenomenal company that is really in a category by itself by trying to compare it to a more mature company, but that is where your judgment as an investor is important. Some people choose to avoid those situations entirely (prognosticating about the future state of the world), but those people will never own a company like Spotify (disclosure: no position) because it truly has few if any real comps (maybe NFLX, but the music licensing bit is important and could hurt gross margins structurally). However, I do think finding that comp that may not be so interesting, even if you're using it to build a bear case to offset your blue-sky view of a situation, is a good discipline to try to have. That company that you may think is boring today was a hot IPO at some point. 

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2 hours ago, Broeb22 said:

I think with any company, profitable or unprofitable, you need to understand their incremental profitability of an additional customer, and try to build an estimate of long-term margins for the business. Without going into all the different parts of the income statement that might change over time, this is generally what you would need to do. 

 

Another way that is interesting is trying to reverse-engineer the current valuation. There are smart people out there willing to pay the current price for whatever company it is. What assumptions are they making, and what assumptions about future growth and margins do you need to make in order to justify the valuation? Do you think those assumptions are reasonable give the information you know about the company and industry? 

 

Your question around what if the entire industry is unprofitable is a good one, and interesting. I would be willing to bet there is some company somewhere in the world doing something similar to them that may be more mature that is actually making a profit, even if its SaaS or something "disruptive". Its possible you could miss a phenomenal company that is really in a category by itself by trying to compare it to a more mature company, but that is where your judgment as an investor is important. Some people choose to avoid those situations entirely (prognosticating about the future state of the world), but those people will never own a company like Spotify (disclosure: no position) because it truly has few if any real comps (maybe NFLX, but the music licensing bit is important and could hurt gross margins structurally). However, I do think finding that comp that may not be so interesting, even if you're using it to build a bear case to offset your blue-sky view of a situation, is a good discipline to try to have. That company that you may think is boring today was a hot IPO at some point. 

I appreciate the response. 

 

To be honest most of my 'valuation' work has been done seeing what prices other smart people are buying at.. The few times I've strayed from that I've got burnt. 

 

Maybe it's best to keep the training wheels on. 

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I've always wondered when a company flips the switch from no earnings to earnings. I see today a lot of stocks that for several years , if not a decade, have made no money or very little. How do you tell they can just flip the switch OR there is no switch to flip and they will have a day of reckoning one day when the markets figure out they can't make good money? I hear Amazon was not fcf positive for a long time yet it was given the benefit of the doubt and it was fulfilled. but how many stocks today are actually 'lying' or ignorant about their future road to profitability and there is in fact never gonna be such a day?

 

Edited by scorpioncapital
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On 10/18/2021 at 5:21 PM, Monsieur_dee said:

To be honest most of my 'valuation' work has been done seeing what prices other smart people are buying at.. The few times I've strayed from that I've got burnt. 

 

If I were in the Army I would walk behind the minesweepers.  Very sensible.

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This is always an interesting mental exercise when I see small businesses go up for sale. $240k for a taco and hot dog shop….why? What do they do? No land? What’s the incremental cost for this or that….why is the brand worth anything(most times it’s not)…end of the day generally my rule of thumb, profitable or not, is what are the assets worth. Add a discount and then adequate return to compensate for my time. ALCO is a good case study. Nothing exciting about the biz buts it’s healthy and profitable. Huge underlying asset. Place that into perspective of both your time, your money, and your current opportunity set. As you would expect, the attractiveness varies greatly. 
 

Conversely I do a semi reasonable number of private deals and your data is limited and the businesses largely unprofitable. My ideal info sets have to do with what’s the growth look like for the entire space. Where does this company stand in terms of having a moat or first mover advantage, and who’s bankrolling it. Just did a deal for shares in a company Emulate. Trading 10x revs and by 2025 the entire TAM will be roughly where the CURRENT EV is. But it’s a tech leader in a rapidly growing and disruptive space with some big financial backers. All I can lose is my investment. I have plenty of multiples of upside even if I’m not entirely right. So I’ll roll the dice. 

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Over the years, our investment choice of 'X' vs 'Y' has almost always been correct.

The disconnect - has been our view, vs the market as to how long it will take until 'X' has its day in the sun (ie: timing), Hence our preferance for the commodity companies, as changing commodity prices are quicker to force a valuation change. Similarly our preference for long investment horizons and averaging down until the market eventually catches up. The issue is that the disconnect can last for years, even when the evidence is as plain as the nose on your face.

 

Lot of people have been pointing out the energy opportunity, for a very long time. Widespread availability of dirt cheap shares, but uninvestable unless you were private money, not beholden to others opinions, and could stand by your own decisions. Today, many of those investors are sitting on share counts in the six and seven digits, dividends are returning as markets normalise - and projected 25%+ cash yields are increasingly considered 'common'. 

 

Ultimately it comes down to the industry/company 'value proposition', how it is changing over time, whether the market will pay for it, and how much. Whether the company is currently profitable, is not particularly useful - heretical!. Case in point; a o/g coy produces product that we cannot do without, the quantity available is continually depleting, and the market will pay the least it can - identical to the drug pusher selling to junkies. Simply trim the relative supply ... and you have a great business!

 

SD  

 

 

Edited by SharperDingaan
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