April 24, 2020 - Over the course of the last few decades, the Internet of Things (IoT) has rapidly evolved and caused major shifts in the way that business is conducted. Large online retailers have been replacing our favorites stores, malls have gradually turned to ghost towns, and investors have begun to value vision over profits.
While the average new company tends to take a couple of years to start to turn profitable, it has become increasingly common for their profitless streak to extend to nearly a decade, with of course, their stock soaring to potentially unjustifiable highs throughout the entirety of that period. Facebook (FB), Amazon (AMZN), and Twitter (TWTR) are all examples of companies that endured extended profitless streaks and came out on the other side profitable and to-par with analyst expectations.
The latest company finding its way to this list is Shopify (SHOP). Shopify is a cloud-based software service that, for a monthly fee, can be a shopping cart solution for online retailers. Despite a profitable quarter in 2019, they have yet to realize a full year of profitability with analysts projecting a loss this year, which of course comes with no surprise due to the COVID19 pandemic.
Shopify and other companies who are trying to leverage their way to profitability pose an interesting challenge for investors who are looking for higher risk and reward; how do you value a company without profits? Since price-to-earnings ratios (P/E ratio) cannot be calculated with nil and negative earnings, many investors turn to discounted cash flow models and relative valuation models.
Discerning which model is best for an investor to use is a question of time available and experience. The Discounted Cash Flow (DCF) model is a great tool for investors, however it has a lot of variables involved and can be time consuming. The DCF model attempts to calculate the value of a company by using what investors believe the company's cash flows will be over a forward time period.
DCF models require investors to make gut calls on discount rates as well as the company’s free cash flows over a period of time including a terminal value to assign to the time beyond the investment period. Assuming there is no debt on the company's balance sheet, the investor will take the Present Value of the company's forecasted Free Cash Flows, including its terminal value, to calculate the company’s worth. The investor will then divide this by shares outstanding to calculate the share value.
For investors with less time or motivation, relative valuation models may be the desired method when examining cases such as Shopify. Relative valuation uses comparable valuations to calculate a multiple, which is used to calculate the company’s enterprise value. This model is advantageous over DCF in that it is much simpler and easier to compare, while the investor may be disadvantaged for using this model compared to a DCF because it is less rigorous and cannot always be compared.
The Enterprise Value-to-EBITDA ratio is an example of a relative valuation. The EV-to-EBITDA model divides the Enterprise Value by the EBITDA to provide a multiple which can be compared between companies much like the PE ratio can be.
Despite the added risk and obstacles that investing in companies without a profit implies, investors can find value in the many companies like Amazon and Shopify. Company’s without profits are more difficult to value and oftentimes require the investor to make gut calls. Despite these challenges, Shopify and other profitless companies can drive growth in portfolios, especially as they near the turning point and begin to realize profits.
