Valuing Companies with Negative Earnings

1
Valuing Companies with Negative Earnings

• Many start-ups have losses or very small profits
  for the initial years due to high marketing or
  RD expenses.
• These companies grow at very high rates.
• Successful companies may increase sales by 100
  times in the first few years.
• Multiples Valuations P/E ratios are absurd if
  there is no earnings to value.
• Using values of these ratios 3 or 5 years out
  does not capture the fact that growth will
  continue for possibly 10 or 15 years.

2
Valuing Companies with Negative Earnings

• Two approaches to valuation
• Change the Accounting
• Work Backwards
• Accounting Standards require that RD is expensed
  immediately however, firms benefit from RD for
  many years to come
• Capitalize RD similar to how capital
  expenditures (purchases of fixed assets) are
  capitalized
• Determine the FCF at stabilization and work
  backwards to get a stream of FCF to value

3
Changing the Accounting

• Currently RD is expensed immediately
• Each year Net Income is reduced by 100 of RD
• Amgen 1998 Net Income 644.3 and RD 630.8.
• Each year Retained Earnings is reduced by 100 of
  RD
• Amgen 1998 No Dividend so RE reduced same as
  above.
• If RD was capitalized (assuming 10 year
  amortization).
• Income is reduced by 1/10 of this years RD as
  well as 1/10 of the RD of every year for the
  last 10 years.
• This is similar to how capital expenditures
  (changes in fixed assets) are capitalized through
  depreciation.
• Book Equity would increase by the amount of
  unamortized RD, i.e. there would be an
  intangible asset on the books.

4
Capitalizing RD

• If you Capitalize RD,
• Income increase in the early years and decreases
  in the later years
• Investing activities increase (still spend the )
• FCF is unchanged
• Book Equity increases.
• So, Capitalizing RD will change the equity and
  book value but not the FCF.

5
Use DCF

• The DCF method to valuing an assets is almost
  always the best alternative.
• The problem is that for some firms there is no CF
  to D
• Solution
• Start at a point in the future when the firm has
  CF

6
Valuing the no CF firm

• Consider Amazon
• In four years, Amazon has built an over 10
  million customer base and expanded its offerings.
• Amazon has invested heavily in its brand-name and
  most people are familiar with the name
• The firm has a high market capitalization
• Currently 9.127 billion
• About a year ago it was 25 billion
• However, the firm has turned little if any profit
• Amazon lies at the heart of the debate of how to
  value internet and start-up firms.

7
Start from the Future

• Trying to determine how a firm is going to go
  from negative profit and cash flow to a FCF high
  enough to justify its market capitalization is
  perplexing
• Solution Approach the problem from another
  angle
• Think about the firm and its industry When do
  you think it will likely begin to stabilize.
• For the internet companies this will likely be 10
  or 15 years from now since this is a very new
  industry

8
Amazon the next Walmart?

• Assume (optimistically) that Amazon continues to
  be the market leader and takes a significant
  percentage of the book and music market share.
• If the company takes 13-12 of the market share
  by 2010, it would have revenues of about 60
  billion.
• The average operating margin (operating cashflow
  / sales) in this industry is about 11.
• So the optimistic scenario may be that Amazon
  has
• 60 billion in revenues
• 7 billion in profit
• Growth will be 15 for 15 years after 2010 and
  stabilize at 5.5
• This results in a value of 38 billion (discount
  rate of 15)

9
Scenario Analysis

• The previous analysis is not a credible forecast
  but a description of what could happen in a best
  case scenario.
• We should also forecast a likely and worst case
  scenario
• Likely 8-10 of the market share - 41 billion
  in revenue, 8 margin resulting in a value of
  19 billion
• Worst Case 5 6 of the market share - 17
  billion in revenue, 7 margin resulting in a
  value of 7 billion

10
Scenario Analysis

• There is much uncertainty with this type of
  analysis and we need to account for that
  uncertainty by weighting the ultimate value by
  its probability of occurring.
• Best Case Value 38 billion and probability
  30
• Likely Case Value 19 billion and probability
  40
• Worst Case Value 7 billion and probability
  30
• Expected Value 21 billion
• Scenario Analysis if very helpful in this type of
  valuation because we are estimating far into the
  future which increases the uncertainty
• Note Each scenario pertains to what Amazon will
  become. We are fairly certain of the growth in
  2010 and beyond. However, if we were not, we
  could alter that as well.

11
Impact of changing Expectations

• Changes to our probabilities results in dramatic
  changes in values.
• If you weight the worst case 70, the likely case
  20 and the best case 10 to reflect the recent
  downturn, the value drops to 12.5 billion

12
From Probability to Reality

• The last step is to determine how Amazon is going
  to go from a negative earnings and cash flow firm
  to one that may earn as much as 60 billion with
  a 7 billion operating profit.
• For internet companies, customer value analysis
  is useful
• Five factors driving customer value analysis
• Average revenue per customer
• Total number of customers
• Cost of getting new customers
• Contribution Margin per customer operating
  profit per customer
• Customer churn rate proportion of customers
  lost each year.

13
From Probability to Reality

• You should compare these numbers now to what they
  must be to get each scenario.
• To get from negative cash flow to 60 billion
  dollars, each of these numbers must be strong and
  improving over time.
• Amazon must continue to build its new customer
  base without losing old customers.
• It must increase the sales to each customer while
  keeping profits down.

14
Risk and Uncertainty

• It is possible that Amazon will realize the best
  case scenario and its value will be 39 billion.
  
• If this is the case, it will appear that the
  market underestimated Amazons ability. This is
  not necessarily true. The market simply factored
  in uncertainty
• As we are seeing recently, not all of the
  internet companies will make it.
• After the invention of the automobile, the US
  market was flooded with auto manufacturers.
  Today, only 3 are left.
• WSJ online now has a link to layoffs and
  shutdowns by dot.coms. To date, 96 firms have
  had major layoffs or shutdown.

15
Amazon Stock Price for one year