There are plenty of companies listed on global stock exchanges that don’t make any money for their investors. Yet despite this, when there is excitement around the company, there is never a shortage of people still willing to invest. Snap Inc. (NYSE:SNAP) – owner of Snapchat – is a high profile social media company in the United States whose losses have grown year on year since their founding.
Afterpay (now Afterpay Touch Group, ASX:APT) is another fairly new company in Australia that is gaining a lot of steam and is also yet to turn a profit. The market believes Afterpay is worth AUD$215 million (before the merger with Touchcorp), and the US market values SNAP at almost USD$20 billion.
This is despite the companies not actually returning any money to their investors yet. So how do you know what a fair price for a company is when there are no earnings to consider?
To understand this, first we need to take a step back.
Traditional Valuation Methods
Ordinarily, a company would be valued on some kind of profit multiple. A Price to Earnings (P/E) multiple valuation is quite common, where the value of the company is derived by multiplying the net profit after tax by a particular multiple. This multiple is market-determined and is generally higher based on how fast the profits are growing. To create a valuation, you decide what multiple the company should trade on (usually based on peer comparisons or historic company P/E), and compare this to the market-assigned P/E.
You can also value a company based on a discounted cash flow, or DCF. A DCF estimates the level of free cash flow (operating cash flow less capital expenditure) the company will earn in future years. The future free cash flow is then discounted back to a present value based on the time value of money (i.e. a dollar today is worth more than a dollar in a year’s time).
At Farnam, we usually use a combination of both of these metrics to give a somewhat balanced view of value.
But if you were to try and value each of these businesses with a P/E or DCF valuation, you would value them close to $0 because there are no current earnings and you don’t know when earnings will materialise.
Valuation or Speculation?
So how does the market get to a valuation of USD$20 billion on nil earnings? Well, it has a lot to do with sentiment, a lot to do with revenue, and a whole lot of guessing.
One broker values Afterpay using 2026 estimated EBIT figures, giving approximately 36% upside to the current price. Another broker uses a DCF using some aggressive (but not completely unlikely) near term profit numbers. This is somewhat reasonable because short term profits seem likely.
With regard to SNAP, though, one broker used a combination of Enterprise Value (EV) to Sales and EV to EBITDA. The broker justifies the assigned EV/Sales multiple by comparing the same metric to other social media companies Facebook and Twitter.
This method could leave a large margin of error because not only do Facebook and Twitter have very different EV/Sales multiples (9.8x and 4.0x respectively), but this speaks nothing to the profit level of each. Facebook makes a handsome profit while Twitter still loses money, so to use sales as a measure of business value seems somewhat misguided. Enterprise Value to EBITDA is a genuine valuation metric though, if in fact the company can project a believable EBITDA number.
In truth, in situations like this I think many analysts can take a “shoot first, ask questions later” mentality, where they come up with the valuation first, and tweak the valuation metrics and methods until it matches. This is because you can hardly have a $0 target price for a stock, and there must be an expectation that the company will, at some point, turn a profit and begin to return capital to their shareholders (contrary to what the SNAP Prospectus states).
This brings us to the main point of the article: that early stage companies that are pre-profits are difficult to value because there are so many unknowns. Investing in loss-making companies with the promise of high growth and higher profits carries an even higher degree of risk. This high risk can come with high reward (look at the Facebook IPO for example), but it can also lead to loss of capital (the Twitter IPO for example). The chance that the company will soon hit critical mass where profits begin to exceed expenses is exciting and is the reason that high growth startup companies receive so much support.
Valuing a business is an important part of every investment strategy. At Farnam, we believe a valuation should be based on earnings with a clear track record so we rarely invest in companies that aren’t making money. Steady and growing profits are just one of the business characteristics that we look for. Not only does this make the valuation much clearer, but it is an indicator of a well-run company with a proven track record in a stable industry.
Sure, companies like I just described might not see explosive growth and become a 10-bagger, but with careful stock selection, we would be over the moon it returned 20% per year.
Farnam does not hold a position in either Snap Inc. or Afterpay Touch Group.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.