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Do profits matter to stock market returns?

If there is one thing everyone knows about the running of businesses, it’s that they have to be profitable in order to survive in the long term. And yet places like Silicon Valley are awash with fast-growing businesses, some of them household names, that have clocked up huge valuations while producing little in the way of profits. What’s going on here, and are profits actually that important?

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If profit is important, why are so many unprofitable companies valued so highly?

You may be familiar with the term unicorn – the name given to privately owned start-ups valued at over $1 billion. When the term was first coined back in 2013, it was done so because finding a start-up with that sort of value was actually quite rare. At the time, 0.07% of tech start-ups could be classified as unicorns. Fast forward to June 2021 and there’s 708 unicorn companies in operation. It’s a far less rare to come across a unicorn now. Yet many of these businesses are still clocking up significant losses each year. 

However, this is hardly confined to the private equity markets – many publicly owned companies have amassed huge valuations while recording relatively small profits, if they make them at all. Many of these companies you’ll know well, including Tesla, Netflix and Uber to name a few. The Australian market is no exception to this trend and many of the strongest performing stocks of the past five years have been built on tiny or non-existent profits, such as those of Xero and Afterpay. 

It’s also worth mentioning that many of these companies are deliberately sacrificing profits to focus on growth. It’s not necessarily that they are incapable of making money but are investing heavily in expanding the business. The classic example of this is Amazon, which has prioritised sales growth over profits since its inception in the 1990s and is now one of the largest companies in the world by market value.

On the other hand, history has shown that many companies that clock up huge valuations with little or no profits eventually come crashing back to earth. For evidence, just look at the US tech bubble and crash from the turn of the century.

Why profits matter

While some businesses have had great success in prioritising long-term growth over short-term profitability, it’s important to remember their valuations are still built around the belief they will be highly profitable in the future. No business can go on making losses to perpetuity.

A business that consistently produces a loss can pose a serious risk to investors capital that goes beyond market fluctuations. That’s because they will continually need to find a way to fund their operations. Most will do so by issuing new stock, which will bring the share price down.

These capital raisings are not always a bad thing for investors. For instance, a successful company may use them to fund new acquisitions that support the businesses growth, but a business that regularly needs to tap its shareholders for more money in order to stay afloat is something to be wary of. 

Do profits tell the full story?

While all businesses are ultimately valued according to perceptions about their future profitability, it is a good idea for investors to look at more than just a company’s profit or earnings metrics.

Net profit figures can be heavily swayed by one-off items such as an asset sale, while adjusted or underlying figures may exclude some ongoing costs investors should know about. There is also the risk that a company is using some unscrupulous accounting techniques to boost its profit numbers, as was the case with Enron. As always, research is key, and it is never a bad idea for investors to take a deep look at any company they are considering investing in.

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?

The bottom line on profits

It’s not unusual for an early stage business to be unprofitable, or to sacrifice short-term profitability for growth. Indeed, many who have done so have gone on to great success. But that doesn’t mean investors, especially those with a long-term buy-and-hold strategy, can afford to ignore profitability.

As always, research is an investor’s best friend. It’s worth taking the time to get a deeper understanding of a business – its financial metrics, track record and the competitive landscape in which it operates – before making an investment decision.

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