How to value an unprofitable company
Another reason profits are important is that they make it easier for an investor to value a stock. One of the most widely used valuation measures is the Price to Earnings, or P/E, ratio. This is calculated by dividing the current stock price by the earnings per share and can help investors compare the valuations of similar businesses.
Valuing businesses that do not make a profit is a little trickier. Depending on the industry, analysts and investors may look at a company’s price-to-sales ratio, which is calculated by dividing the stock price by the company’s revenue per share, or by estimating its discounted free-cash flows, a complex method that involves projecting its free cash flow into the future and discounting them at an appropriate rate.
But it’s a good idea to look beyond any single measure. Depending on the business and industry, you may also want to look at how quickly a company is growing, its debt levels, its market share, management track record and incentives and any relevant competitive edges or disadvantages it may have.
These measures can help when comparing these businesses to their peers, but, once again, it’s important to remember that a company’s valuation comes down to perceptions about its long-term profitability.
It’s also a good idea to look at why a business is unprofitable. Is it in its early stages of growth or is it a mature business that has been wrong-footed by a competitor or changes in the market? Is it capable of being profitable right now if it stopped investing for growth or is it weighed down by high operating costs?