Valuing Firms with Negative Earnings
Valuation of loss-making companies at huge valuations is the new norm until...
We all like life to be a bed of roses. Or at least look life through rose-tinted glasses. In reality, life has its ups and downs. Companies are no different. In fact, a recent study by Fortune magazine showed that only 12% of Fortune 500 firms in 1955, still existed in 2016.
When it comes to valuing firms with negative earnings, what do we actually do. And how do we differentiate between a cyclical downturn and a death knell ? Closer to home now, given the state of retail, and the record number of closures because of e-commerce disruption. How would you actually value a company facing a very uncertain future.
a) Are the problems temporary and firm-specific ? The expectation is that earnings will recover in the near-term and we can normalise earnings.
b) Are the problems sector-wide or Market-driven ? Depending on where we are at on the cycle e.g. commodities. We may adjusted the expected growth rate in the near periods to reflect cyclical changes. Alternatively, we use normalised earnings rather than current earnings.
c) Are the problems long-term strategic and/or operating issues ? We face the challenge of evaluating whether the downward shift is a permanent one. If so, we have to scale down revenue and margins expectations. And use a higher discount rate to account for higher risks.
d) Are the problems worsened by financial leverage. We assess whether future weak business performance will trigger bankruptcy because of the breaching of loan covenants. The recent cases of over-leveraged public companies in the oil-and-gas sector, going bankrupt, is a sudden but potentially predictable outcome.
The biggest challenge valuers face is the speed of disruption to traditional businesses. A good valuer will be able to assess and evaluate and provide a range of options to valuation.