An Investment Opinion
Valuation Metrics for Unprofitable Companies
But how is it that one company's losses are better than another's? There are traits that are too consistent to be attributed to a guessing game. Throughout history companies have been valued almost exclusively upon their potential for future earnings. So how is it that Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY) and America Online (NYSE: AOL), three members of the Internet royalty, have been granted massive valuations upon scant net earnings or even massive operating losses? And why have TheStreet.com (Nasdaq: TSCM) or Value America (Nasdaq: VUSA), with their similarly dreadful current financials, been cast off onto the slag heap of doom and irrelevance?
It has got to be more than a simple case of slippery little concepts like "potential" or "buzz."
At the same time, any Buffett-like analysis of future cash flows and intrinsic value would likely cause such an investor to recoil in horror. How can one expect eBay, with a current price-to-earnings ratio of 1600, to ever meet its expectations of value? How about poor Amazon, the poster child of companies that have never made a dime in profits? In the long run, what good are "narrowing losses" unless they become operating profits? So just what is the difference between Amazon.com's Return on Equity of -237 and Value America's -278?
The message that we can take from this is that we do not yet know which company is going to succeed, but we're pretty cocksure about the ones that have no chance.
In fact, there are some measures that can give us a good idea of where the greatest potential for gains in the Internet economy lie. Better yet, they are not based on smoke and mirrors or dogs and ponies, but rather on good, hard numbers. Because what is not in discussion is whether the Internet-based economy is a bell that can be unrung, and some companies are undoubtedly going to profit hugely from it, now and in the future. Your job, should you choose to accept it, is to figure out which ones.
The following measures can provide a reasonable proxy to predict growth and profitability. Reasonable, because they still do not serve as good a predictive tool as a discounted cash flow model, but if a company's cash flows are negative or minuscule, then that's not going to do you much good anyway.
Item 1: Growth in Gross Sales Sufficient to Discount Current Operating Losses
This is the simplest one of the three. If an unprofitable company does not show much in the way of sales growth, then it makes it much easier to discount the possibility of it ever improving its bottom line. The reason for this is simple: unprofitable companies in immature sectors are being valued on potential. Low sales growth, low potential.
For example, autobytel.com (Nasdaq: ABTL) increased its sales from $6.4 million to $10.6 million between Q3 1998 and Q3 1999, a growth rate of 65%. At the same time, the company's share price has dropped by more than 75% since its March 1999 IPO. Why? Because the nominal and actual rate of growth is far below what investors believe will be necessary to bring autobytel.com into profitability. If this company cannot deliver a truly outstanding rate of growth of net sales, there is no reason for investors to believe that it will ever deliver bottom line returns.
Item 2: Gross Profits Compared to Sales and Marketing Expenditures
It's fairly easy to imagine that a company that is not profitable and also growing sales at a low rate is not an ideal place to put your investment dollars. But what about some of these Internet companies that are growing their sales at a substantial rate but are still being punished by the market for not being profitable? Is the market being shortsighted? Why can Amazon get away with operating losses but iVillage (Nasdaq: IVIL) cannot, even though both have triple digit sales growth rates for the trailing 12 months?
One clue is to look at how much in marketing the company is having to spend to achieve those growth rates. But instead of looking at percentages, it may be more telling to use absolute dollars and compare gross profits to sales and marketing expenditures.
Beyond.com (Nasdaq: BYND) is a telling example. It has an annual sales growth rate of nearly 400%, yet has been shellacked by the market. But a comparison of the gross profit and marketing numbers from the most recent 10-Q with the previous year's is telling. In the third quarter of 1998, Beyond.com's gross profit was $1.4 million and its sales and marketing expenditures were $7.9 million. In the same quarter of 1999, gross margin had grown to $4.3 million, but marketing expenses had ballooned to $24.2 million. Beyond.com had best figure out how to better leverage its marketing dollars or it is not long for this world.
Item 3: Cost vs. Benefit for Each New Customer Acquired
This measures the expense of acquiring each customer and compares this to the annualized revenue of the company. To measure this, one must have access to the total sales and marketing expenses for the lifetime of a company, and the total number of customers acquired. eBay, for example, has a customer base of 10 million, and has spent a total of $130 million in marketing to acquire those customers, for a cost of $13 per customer. Since eBay's sales are currently $896 million on an annual run rate, it derives $89.60 for each customer per year. So eBay's marketing expenditures per customer are recouped in three months.
This can be contrasted with other companies, the worst one I can find being Value America, with its current marketing expenditure rate of return at just under 12 years per customer. Run these numbers on several companies and you will quickly begin to understand why some companies are slated as the kings of the hill, while others are suffering in relative squalor, even though both may be currently losing money.
Take a few 'Net companies, some highly valued and some not so, and run the three comparisons above. You may find that the market is not so crazy after all. Moreover, you may find some companies that have been unjustly punished, that have more potential than the market may currently believe.
Bill Mann (TMFOtter on the boards)