Investing in unprofitable companies is generally a high-risk, high-reward proposition, but one that many investors seem willing to make. For these investors, the possibility of stumbling upon a small biotech company with a potential blockbuster drug or a junior miner that unearths a major mineral discovery means the risk is well worth taking.
While hundreds of publicly traded companies report losses quarter after quarter, a handful 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.
Key Takeaways
- Some investors are willing to take the risks associated with investing in companies with negative earnings because there is the potential for high rewards.
- Negative earnings can be caused by temporary or permanent issues.
- As an investor, determine if negative earnings posted by a mature company are just a temporary issue.
- There are several techniques to help investors value unprofitable companies, including discounted cash flow and enterprise value-to-EBTIDA.
- Make sure your investment decisions are justified by your valuation techniques.
What Causes Negative Earnings?
Negative earnings or losses can be caused by temporary (short- 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 like lumber companies during the collapse of the U.S. housing market back in 2008.
Longer-term problems may have to do with fundamental shifts in demand due to changing consumer preferences. This was the case with Blackberry’s dramatic decline in 2013 due to the popularity of Apple and Samsung smartphones. This can also occur with technological advances that may render a company or sector’s products obsolete, such as compact-disc 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 depend on the extent of the temporary problems and how their rate of protraction.
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 outweigh the risk—such as technology, biotechnology, and mining.
Investing in Companies With Negative Earnings
For a mature company, a potential investor should determine whether the negative earnings phase is temporary 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 be back in the black in the future.
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 Meta are much lower than the odds that it may be a mediocre performer at best and a complete bust 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.
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.
Valuation Techniques
Since price-to-earnings (P/E)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-to-EBITDA and price-to-sales. These valuation methods are discussed below.
Discounted Cash Flows (DCF)
Discounted cash flow essentially attempts to estimate the current value of a company and its shares by projecting its future free cash flows (FCF) 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 on companies with negative earnings, the problem lies in its complexity.
An investor or analyst has to come up with estimates for:
- The company’s free cash flows over the forecasted period
- A terminal value to account for cash flows beyond the forecast period
- The discount rate. A small change in these variables can significantly affect the estimated value of a company and its shares
For example, assume a company has 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. If the company has 50 million shares outstanding, each share would be worth $4.91 or $245.66 million ÷ 50 million shares. 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.
Enterprise Value-to-EBITDA
In this method, an appropriate multiple is applied to a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) to arrive at an estimate for its enterprise value (EV). EV is a measure of a company’s value and equals equity plus debt minus cash in its simplest form. There are pros and cons of using this method:
- 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.
A company may post EBITDA of $30 million in a given year. An analysis of comparable companies reveals they trade at an average EV-to-EBITDA multiple of 8. Applying this multiple 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 is, therefore, $220 million or $4.40 per share.
Other Multiples
Other multiples such as the price-to-shares ratio, or price/sales, are also used in many cases, especially technology companies when they go public:
- Twitter (now X), which went public in Nov. 2013, priced its IPO shares at $26, or 12.4 times its estimated 2014 sales of $1.14 billion.
- Meta (META), formerly Facebook, was then trading at a sales multiple of 11.6 times and LinkedIn was trading at a sales multiple of 12.2 times.
Twitter Inc. changed its name to X Corp. in April 2023 after being purchased by Elon Musk in 2022.
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 Food and Drug Administration (FDA) approval, companies are valued on the basis of where they are in the approval process (Phase I clinical 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 IIItrials as a diabetes treatment will be compared with other similar companies to get an idea of its valuation.
Valuation Matches Risk-Reward
Your investment decisions should be justified by the valuations of the companies in which you invest. 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 a chance to triple or quadruple your initial investment. If there is a risk of a 100% loss of your investment, a potential best-case return of 50% is hardly enough to justify the risk.
Be sure to 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.
What Are Negative Earnings?
If a company has negative earnings, it means it reported a loss for the specified time period. This may mean that a company is either losing money and is experiencing some financial difficulty. In other cases, companies may post negative earnings (or losses) if they are spending more than they did in the past. This isn't necessarily a bad thing as it may indicate the company is investing more in its future.
What Does Negative Retained Earnings Mean?
Retained earnings refer to the money left over from a company's profit after it pays direct and indirect costs, such as dividends and income taxes. This is noted in the equity section of the balance sheet. So if a company earned $10,000 last year and $10,000 this year (after accounting for costs), its retained earnings are $20,000.
Negative retained earnings refer to the total amount of loss posted by a company when it exceeds any previously recorded profit. So if the company above posted a loss of $20,000 this year instead of a profit, it ends up with negative retained earnings of $10,000.
How Can Companies Have Negative Earnings and Positive Cash Flow?
It is possible for companies to have negative earnings and positive cash flow at the same time. Companies may generate cash by borrowing money or through other cash inflows, such as selling off assets or reducing its labor force, while posting a net loss for a certain reporting period. The cash that it brings in is able to offset any losses it may have during that period.
The Bottom Line
Investing in companies with negative earnings is a high-risk proposition. However, using an appropriate valuation method such as DCF or EV-to-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.
