High-Growth and Negative-Earnings Companies

Why this matters

Some of the most talked-about companies report losses. They're spending heavily to grow, and their value depends almost entirely on profits that are years away. The tools from Part 4 seem to break: there's no price-to-earnings ratio, and a DCF starts from negative cash flow. The principle hasn't changed, though. A business is still worth the cash it will eventually produce. What changes is how far ahead you have to look, and how uncertain the view is.

Why revenue multiples aren't enough

With no earnings to use, investors often quote price to sales. Other Multiples: P/S, P/B, and EV/EBITDA introduced it and gave the warning that applies here: a dollar of revenue is worth very different amounts depending on how much of it becomes profit.

A revenue multiple can be translated into something more familiar. A company valued at 15 times its sales, which will one day keep 20% of sales as profit, is valued at 75 times the profit it would earn on today's sales at that future margin. Its price makes sense only if sales grow many times over before that margin arrives.

Working from maturity

Instead of forecasting each year's loss, start at the end.

1. How large could revenue be when growth slows to an ordinary pace?
2. What margin does a mature business of this kind earn?
3. What would that profit be worth at that point?
4. What is that worth today, discounted at a rate that reflects the risk?
5. How many shares will exist by then?
6. What's the chance it gets there at all?

	Amount
Revenue today	$100 million
Free cash flow today	$40 million outflow
Shares today, and share price	50 million at $30
Market value today	$1,500 million, or 15 times sales
Revenue in year 10, with growth slowing from 40% to 6%	$600 million
Free cash flow margin at maturity	20%
Free cash flow in year 10	$120 million
Value in year 10, at 20 times free cash flow	$2,400 million
Value today, discounted at 11% a year	$845 million
Shares by year 10	65 million
Value per share today	$13.00

In this forecast Company H's sales grow sixfold in ten years, which is about 20% a year, and it becomes a solidly profitable business. Even so, the estimate is $13 a share against a price of $30. The forecast isn't pessimistic. The price simply assumes much more.

Each step deserves a comment.

• Revenue at maturity should be checked against the size of the market the company sells into. Growth slows as a company gets larger, because each year's increase has to be bigger than the last in dollars.
• The mature margin is best taken from established companies with a similar way of doing business, not from management's long-term target.
• The discount rate is higher than for a steady business, because the outcome is less certain. Cost of Capital explained why riskier cash flows are discounted at higher rates.

The rest of this lesson is for members

Still to come in this lesson: Dilution, What the price requires, How sensitive it is, What history says, Signs of a real business underneath, the key takeaways, and 2 quiz questions with explanations.

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