Investing in unprofitable companies is generally a high-risk, high-reward proposition, but one that many investors seem willing to make. For them, the possibility of stumbling upon a small biotech with a potential blockbuster drug, or a junior miner that makes a major mineral discovery, makes the risk well worth taking.

While hundreds of publicly traded companies report losses quarter after quarter, a handful of them may go on to attain great success and become household names. The trick, of course, is identifying which of these firms will succeed in making the leap to profitability and blue-chip status.

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What causes negative earnings?

Negative earnings–or losses–can be caused by temporary (short-term or medium-term) factors or permanent (long-term) difficulties.

Temporary issues can affect just one company –  such as a massive disruption at the main production facility – or the entire sector, such as lumber companies during the U.S. housing collapse.

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Longer-term problems may have to do with fundamental shifts in demand due to changing consumer preferences (such as Blackberry’s collapse in 2013 due to the popularity of Apple and Samsung phones), or technology advances that may render a company or sector’s products obsolete (such as compact-disk makers in the early 2000s). 

Investors are often willing to wait for an earnings recovery in companies with temporary problems, but may be less forgiving of longer-term issues. In the former case, valuations for such companies will depend on the extent of the temporary problems and how protracted they may be.

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In the latter case, the rock-bottom valuation of a company with a long-term problem may reflect investors’ perception that its very survival may be at stake.
Early-stage companies with negative earnings tend to be clustered in industries where the potential reward can far outweighs the risk – such as technology, biotechnology and mining.

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Valuation techniques

Since price/earnings ratios cannot be used to value unprofitable companies, alternative methods have to be used. These methods can be direct – such as discounted cash flow (DCF) – or relative valuation. Relative valuation uses comparable valuations (or “comps”) that are based on multiples such as enterprise value / EBITDA and price/sales. These valuation methods are discussed below:

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DCF essentially attempts to estimate the current value of a company and its shares by projecting its future free cash flows and “discounting” them to the present with an appropriate rate such as the weighted average cost of capital (WACC). Although DCF is a popular method that is widely used to value companies with negative earnings, the problem lies in its complexity.

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An investor or analyst has to come up with estimates for (a) the company’s free cash flows over the forecasted period, (b) a terminal value to account for cash flows beyond the forecast period, and (c) the discount rate. A small change in these variables can significantly affect the estimated value of a company and its shares.

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For example, assume a company has free cash flow (FCF) of $20 million in the present year. You forecast the FCF will grow 5% annually for the next five years, and assign a terminal value multiple of 10 to its year five FCF of $25.52 million. At a discount rate of 10%, the present value of these cash flows (including the terminal value of $255.25 million) is $245.66 million.

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If the company has 50 million shares outstanding, each share would be worth $245.66 million ÷ 50 million shares = $4.91 (to keep things simple, we assume the company has no debt on its balance sheet).

Now, let’s change the terminal value multiple to 8, and the discount rate to 12%. In this case, the present value of cash flows is $198.61 million, and each share is worth $3.97. Tweaking the terminal value and the discount rate resulted in a share price that was almost a dollar or 20% lower than the initial estimate.

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Enterprise Value / EBITDA:

In this method, an appropriate multiple is applied to a company’s EBITDA (earnings before interest, taxes, depreciation and amortization) to arrive at an estimate for its enterprise value (EV). EV is a measure of a company’s value and in its simplest form, equals equity plus debt minus cash. The advantage of using a comparable valuation method like this one is that it is much simpler (if not as elegant) than the DCF method.

The drawbacks are that it is not as rigorous as the DCF, and care should be taken to include only appropriate and relevant comparables. In addition, it cannot be used for very early-stage companies that are still quite far from reporting EBITDA.

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For example, a company may post EBITDA of $30 million in a given year. An analysis of comparable companies reveals that they are trading at an average EV/EBITDA multiple of 8. Applying this multiple therefore gives the company an EV of $240 million. Assume that the company has $30 million in debt, $10 million in cash, and 50 million shares outstanding. Its equity value it therefore $220 million or $4.40 per share.

Other multiples

Other multiples such as price/sales are also used in many cases, as for instance technology companies when they go public. Twitter (NYSE:TWTR), which went public in November 2013, priced its IPO shares at $26, or 12.4 times its estimated 2014 sales of $1.14 billion. In comparison, Facebook (Nasdaq:FB) was then trading at a sales multiple of 11.6 times and LinkedIn (NYSE:LNKD) was trading at a sales multiple of 12.2 times.

Industry-specific multiples

These are used to value unprofitable companies in a specific sector, and are especially useful when valuing early-stage firms. For example, in the biotechnology sector, since it takes many years and multiple trials for a product to gain FDA approval, companies are valued on the basis of where they are in the approval process (Phase I trials, Phase II trials etc.), as well as the disease for which the treatment is being developed.

Thus, a company with a single product that is in Phase III clinical trials as a diabetes treatment will be compared with other similar companies to get an idea of its valuation.

Points to consider

• Is the unprofitable phase likely to be temporary or permanent? For a mature company, a potential investor should determine whether the negative earnings phase is a temporary one, or if it signals a lasting, downward trend in the company’s fortunes. If the company is a well-managed entity in a cyclical industry like energy or commodities, then it is likely that the unprofitable phase will only be temporary and the company will return to profitability in future.

• Early-stage companies are not for the conservative investor: It takes a leap of faith to put your savings in an early-stage company that may not report profits for years. The odds that a start-up will prove to be the next Google or Facebook are much lower than the odds that it may be a mediocre performer at best and a complete burst at worst. Investing in early-stage companies may be suitable for investors with a high tolerance for risk, but stay away if you are a very conservative investor.

• Check valuations and evaluate the risk-reward:  The company’s valuation should justify your investment decision. If the stock appears overvalued and there is a high degree of uncertainty about its business prospects, it may be a highly risky investment. The risk of investing in an unprofitable company should also be more than offset by the potential return, which means that if the company succeeds, you should triple or quadruple your initial investment. If there is a risk of 100% loss of your investment, a potential best-case return of 50% is hardly enough to justify the risk.

• Management is the key:  Ascertain whether the management team has the credibility and skill to turn the company around (for a mature entity) or oversee its development through its growth phase to eventual profitability (for an early-stage company).

• Use a portfolio approach:  When investing in negative earnings companies, a portfolio approach is highly recommended, since the success of even one company in the portfolio can be enough to offset the failure of a few other holdings. The admonition not to put all your eggs in one basket is especially appropriate for speculative investments.

The Bottom Line

Investing in companies with negative earnings is a high-risk, high-reward proposition. However, using an appropriate valuation method such as DCF or EV/EBITDA, and following common-sense safeguards – such as evaluating risk-reward, assessing management capability, and using a portfolio approach – can mitigate the risk of investing in such companies and make it a rewarding exercise.

BEWARE: This article was culled from Investopedia.