Q: Typical valuation metrics like the P/E ratio don't really work for fast-growing companies with no profits. What should I use instead?
Rapidly growing companies can make for some pretty lucrative investment opportunities. As one example, Tesla's stock is up more than 2,000% since its 2010 IPO, despite the fact that the company has yet to produce a full-year profit. However, this lack of profitability can make them difficult to value.
There are several metrics you can use to value stocks without earnings. One method I like to use involves a combination of a company's price-to-sales ratio and its revenue growth rate (I'll invest in a company with no earnings, but never in a company with no sales).
Let's look at a pair of examples. One of my favorite high-growth companies that has yet to turn a serious profit is Square. The fintech company has a market capitalization of $21.8 billion and its second-quarter revenue, when annualized, translates to a price-to-sales ratio of 14.2. Square's adjusted revenue grew by 60% over the past year.
Next, yet-to-be profitable social media company Snap trades for a price-to-sales ratio of 11.5 based on its annualized second-quarter sales and just reported 44% revenue growth. So this is a good example of how one of these variables can offset the other. Square trades for a more "expensive" price-to-sales ratio, but also is growing at a faster rate.
There are other valuation metrics that don't involve earnings that you can use as well. Book value per share is a good one, as are the debt-to-equity and the enterprise value-to-EBITDA ratios. And if a company is particularly cash-rich, that should also be taken into consideration. The point is that even if a company doesn't have earnings, there are plenty of metrics you can use to get a pretty thorough picture of its valuation.
Matthew Frankel, CFP® owns shares of SQ. The Motley Fool owns shares of and recommends SQ and TSLA. The Motley Fool has the following options: short September 2018 $80 calls on SQ. The Motley Fool has a disclosure policy.