What’s An Unprofitable Business Worth? 

Valuing High-Growth, Loss-Making Companies

Recent IPOs by high-growth, loss-making businesses such as Lyft and Uber have highlighted a sharp divide among investors over a simple question: What is a company worth? For traditional or value investors, a company’s value is a function of its current and historical profits and cash flows. For momentum or growth investors, however, value is a function of potential future profitability and cash flows. Which side is correct?

Growth investors have the upper hand

For the last decade or so, growth investing – which prioritizes future growth prospects over historical profit performance – has enjoyed record success. Investors that piled into high-growth, loss-making companies (HGLMCs) like Amazon, which only became profitable several years after its listing, and Facebook, which took several years to achieve profitability after its launch, have earned exponential returns. The halo effect of these successes meant that companies from Tesla to Twitter enjoyed a long and relatively steady boom in their share prices, despite posting substantial losses.

However, some cracks may be showing in the growth investment approach.

At the beginning of the year, investment banks and market commentators were claiming that loss-making Uber could be worth as much as $120 billion, and that loss-making Lyft could be worth $25 billion. These much-hyped, pre-IPO valuations were based on high expectations for future growth and profitability.

But the subsequent IPOs of these businesses showed that not everyone was buying the growth story. Uber is currently trading at a market cap of around $70 billion and Lyft at $17 billion, well below the levels anticipated at the start of their IPO processes.

The difference, it seems, is that while the companies’ early, private equity investors were looking optimistically ahead to a high-growth future, many retail and institutional investors instead focused on the present lack of profitability and positive cash flows. This has resulted in multi-billion-dollar gaps between what the two groups believe these businesses to be worth.

What is a company worth?

Valuing a company has always been a relative, rather than an exact science, and even Warren Buffett has been wrong about the “true” value of a business – that is, the value it can sustainably command in a public market.

There are several ways to determine what a business is worth. Historically, investors and corporate finance professionals have often taken a metric, such as net earnings or revenues, and applied a multiplier to that number to obtain a valuation.

Price-earnings (P/E) multiples, for example, are a popular option. The P/E ratio measures what investors are paying for $1 of earnings. When a new company must be valued, investors may look at its historical earnings and estimate a likely price for the company based on the average multiples for other, similar companies. Typically, high-growth companies – or companies in high-growth industries – can command higher multiples than lower-growth ones.

The problem, however, is that a company may have rapidly growing revenues and a rising number of customers, but negative earnings. P/E multiples are obviously not helpful in valuing this type of business. Further, many of today’s HGLMCs are entirely new types of businesses and there are no established players to compare them to for the purpose of generating appropriate multiples.

Absent other alternatives, then, many investors turn to discounted cash flow (DCF) analysis to value HGLMCs.

DCF analysis works by projecting a company’s future free cash flows (FCFs) and then discounting these using an appropriate discount rate – usually the company’s weighted average cost of capital – to generate an estimate of the company’s present value.

To predict FCFs, investors must make various assumptions about the likely future state of the company and its industry. They must project how quickly the market the company operates in will grow and what percentage market share the company will capture. They must also project future revenues, operating margins, capital costs, and return on invested capital. All these projections are based, in part, on best guesses.

Given the number of estimates involved, different investors can produce very different FCF projections and thus, very different valuations. Optimistic assumptions by private investors about future market growth or margins will lead to rosy valuations, which may prove unsustainable in more-skeptical public markets.

This seems to be what happened with the ride-hailing company IPOs. While early private investors believed that ride-hailing businesses would ultimately capture a large share of the multi-trillion-dollar transportation market and turn profitable, many later-stage investors appear to have concerns about the companies’ ability to generate profits no matter how big their market share.

In large part, then, an investor’s position on the question of what an HGLMC is worth is a matter of philosophy.

On the one hand, there are those that believe we are in the midst of a technological revolution that will disrupt and destroy existing industries from traditional banks to traditional energy producers to traditional taxi services. These individuals believe that old, backward-looking metrics ignore the radically changed environment and understate the true value of disruptive HGLMCs.

On the other hand, there are those who argue that even disruptive businesses must show a capacity for creating economic value and generating profits. These investors believe that fundamental metrics such as operating margins, cash flow, and return on equity remain relevant, even in rapidly changing, high-growth markets. They are skeptical in their projections for the future.

For the last decade, the growth believers have held the upper hand. Many value investors are waiting for the pendulum to swing.

View tutorial intro videos related to this topic. Just click one of the links below.

Intuition Know-How has a number of tutorials that are relevant to equity valuation:

• Equity Valuation – An Introduction
• Industry & Company Analysis
• Equity Returns Analysis
• Equity Valuation – DCF Models
• Equity Valuation – Other Methods
• Corporate Valuation – An Introduction
• Corporate Valuation – DCF Analysis

Optimism or complacency: The Fed’s Basel capital buffer decision

Under US President Donald Trump, federal agencies have implemented a broad program of financial deregulation. New measures have limited the number of banks deemed systemically important and freed the de-designated banks from the need to undergo stress tests or submit insolvency plans. The Federal Reserve has lowered the minimum liquidity coverage ratio for some of the country’s larger banks and, more recently, has voted not to impose the countercyclical capital buffer (CCB) created by Basel III. These measures have helped boost bank profitability. Some, however, worry this deregulation agenda may create new risks.

In March, the Federal Reserve voted to keep the CCB for large banks operating in the US at 0%. The CCB is a mechanism introduced by Basel III to require banks to increase their capital reserves during periods of strong economic growth so that they are adequately capitalized when the economic cycle turns.

As the US enters the tenth year of its economic recovery – now one of the longest in US history – some have suggested that the Fed should activate the CCB to encourage banks to increase capital ahead of an inevitable downturn.

However, according to a recent speech on the CCB by the Fed’s Vice Chair for Supervision, Randal K. Quarles, the Fed sees “many reasons to expect relatively strong growth in the coming years, supported by gains in the productive capacity of the economy,” and, therefore, is comfortable maintaining a zero CCB in what amounts to “a normal risk environment.”

According to Quarles, then, the Fed sees no sign of a potential slowdown in the coming years and, thus, no need to require banks to build up their reserves.

However, the Fed also voted in March to hold interest rates steady and announced it would be slowing the process of unwinding its sizeable balance sheet, with the goal of ending the unwinding entirely in September. The Fed also released projections for the upcoming year, cutting its 2019 growth forecast to 1.9%.

Many observers interpreted this dovish decision as a sign of the Fed’s growing concern about the risks posed by slowing US economic growth, global trade disputes, and the end of the economic stimulus generated by the 2017 tax cuts.

Therefore, while the Fed’s decision to keep the CCB at zero suggests confidence in the strong economy, its decision to end rate tightening suggests significantly more uncertainty about the economic outlook. Some critics have pointed out that the CCB is intended for exactly such periods of economic uncertainty.

According to Gregg Gelzinis, a policy analyst at the Center for American Progress, “The Fed’s refusal to activate the CCB completely ignores the lessons learned from the 2007–2008 financial crisis. During positive economic times, as risks develop under the surface, regulators should strengthen financial safeguards to bolster the banking system in advance of the next economic downturn. As noted in the Fed’s own financial stability report… valuations across many asset classes are stretched, corporate leverage is near a 20-year high, and riskier firms have been increasing their debt the most. Now is the time for regulators to enhance the resiliency of the banking sector.”

In contrast, however, Quarles argues that the Fed’s current requirements are adequate.

“Because we set high, through-the-cycle capital requirements in the United States that provide substantial resilience to normal fluctuations in economic and financial conditions, it is appropriate to set the CCB at zero in a normal risk environment,” he said.

History shows that financial services regulation is cyclical. During times of financial crisis and recession, regulators enact new rules addressing the weaknesses that caused the crisis. Then, during expansions, complacency sets in and regulatory frameworks are dismantled until a new financial vulnerability ignites a new crisis.

As the US recovery continues, many believe that banks have put the errors of the past behind them and are on a firm footing, justifying further deregulation and monetary accommodation. Others worry that we are witnessing the complacency that precedes a fresh crisis. Developments over the next eighteen months may offer some clarity about who is correct.

Know-How

Intuition Know-How has a number of tutorials that are relevant to ALM and FinTech:

• Basel III – An Introduction
• Basel III – Pillar 1 & Capital Adequacy
• Basel III – Measurement Approaches
• Basel III – Liquidity & Leverage
• Basel III – Pillar 2 & ICAAP
• Basel III – Pillar 3 & Risk Reporting

Tech IPO rush tests market appetite for unprofitable companies

This year promises to offer a flurry of tech unicorn listings – that is, the initial public offerings (IPOs) of privately held technology companies with valuations over $1 billion. Ride-hailing company Lyft and electronic bond-trading platform TradeWeb both listed in late March at $1 billion-plus valuations. In April, the markets welcomed social media site Pinterest. Other tech unicorn IPOs in the pipeline for 2019 include ride-hailing company Uber, data mining company Palantir, coworking giant WeWork, and workplace messaging service Slack. But early signs suggest that the market’s appetite for loss-making companies may be weaker than anticipated.

Amid much fanfare, Lyft beat arch-rival Uber to market on March 28, debuting at $72 a share, a price that valued the loss-making company at around $24 billion and raised $2.34 billion in fresh capital. The shares were reportedly up to 20 times oversubscribed and, on Lyft’s first trading day on the Nasdaq, closed at $78.

It seemed that, given Lyft’s 103% year-on-year growth in revenue for 2018, the market was willing to overlook its $911 million loss – a loss that was up 32% from 2017. Many interpreted Lyft’s strong IPO as a sign that the market was hungry for high-growth tech listings, regardless of profitability. This came as a relief – because a host of such unprofitable, multi-billion-dollar tech companies will debut this year, it’s important that there is robust investor appetite for them.

However, the initial optimism about Lyft seemed to sour after a few days. By mid-April, the shares were trading at closer to $60 as analysts’ notes pointed to an uncertain path to future profitability.

Lyft’s post-IPO performance was broadly in line with the historical performance of newly listed companies. US professor Jay Ritter, who studies IPOs, told the Wall Street Journal that, on average, IPOs perform well on their first trading day but underperform the market over the subsequent three years, by an average of nearly 20%. Facebook, for example, traded below its IPO price for well over a year after listing.

Nevertheless, Lyft’s struggles were a marked contrast to the performance of TradeWeb, which debuted on the Nasdaq in early April at a price of $27 a share and is now trading at close to $40.

Unlike Lyft, Tradeweb is already profitable, reporting net income of $160 million on $684 million in revenue in 2018. This contrast between the performance of the two IPOs suggests that investors may not be as indifferent to profitability as the Lyft IPO initially indicated.

Lyft’s struggles have had an effect on the IPO market. Pinterest, which started trading in mid-April, was initially expected to price its IPO close to the almost $22 a share at which it sold a stake to private investors in 2017. However, in the wake of Lyft’s weak performance, the company’s SEC filing documents priced it at an IPO range of $15 to $17 a share. Ultimately the IPO priced at $19 a share – higher than the indicated range but lower than initially hoped.

This may bode ill for the year’s other big listings. The initial valuation of Uber, for example, has been pegged as high as $120 billion, making it among the world’s 100 largest listed companies by market cap.

Now, some are wondering if the Uber IPO will live up to the hype. According to its April SEC IPO filing, in 2018, Uber reported a net loss of $1.8 billion on gross bookings (revenues before payments to drivers are deducted) of $50 billion. Uber’s topline growth slowed throughout the year, while its losses narrowed. With such large losses and slowing growth, some question whether Uber can sustain its lofty private valuation once publicly listed.

Questions have also been raised about the fate of other loss-making unicorns like Palantir and Airbnb. As private companies, neither of these have reported financial statements. However, both are reportedly unprofitable. And both are planning to list this year. With investors potentially wary of unprofitable businesses, their anticipated valuations may be lower than their private equity owners and founders hope.

Despite concerns about potential pricing weakness, the tech IPO bonanza is widely seen as a positive sign for US stock markets. The IPO market started the year on a weak note, particularly in Europe. In the first quarter of 2019, the Financial Times reports that proceeds from stock market listings in Europe were down 99%, while UK proceeds fell by 85%, and Chinese and US proceeds halved. The star-studded lineup of new IPOs in the US for the rest of the year is thus very good news.

Know-How

Intuition Know-How has a number of tutorials that are relevant to IPOs and equity markets, including:

• US Equity Market
• UK Equity Market
• European Equity Market
• Equity Markets – An Introduction
• Equity Markets – Issuing
• Equity Trading – An Introduction

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