Uncertainty, another source of leverage.

In my last post on $KING I highlighted why current profitability isn’t necessarily king (pun intended). Today,  I thought I’d follow up and expand on a few points of differentiation between profitable companies and non profitable ones.

First a couple of superficial benefits of being a non profitable company vs. one that’s profitable.

Firstly, companies without profits have PE ratios and other profit multiples that are “NM” or “NA”. This can force investors to look further out to the future and to focus more on the potential of the company. Alternatively, this can also cause investors to focus on alternative metrics, whether it is DAUs / MAUs (daily or monthly active users) or TAM (total addressable market) etc. and focus on those metrics relative to others in an all relative valuation game.

Contrast that with a company that might be barely profitable, now you might have a 50x or 100x P/E ratio or an EV/EBITDA that’s 3 or 4 times that of the market’s, suddenly it’s an expensive company, and now investors can and do focus on FY ’14 or FY ’15 numbers.

A second broad point about non profitable companies is that since their earnings are negative they will report shares outstanding without including stock options or RSUs - even in their diluted numbers. The reason – as @herbgreenberg pointed out here - is that if the company included these options then it would have “spread out” the losses over more shares – hence shrinking the loss per share.

The rub and in this case – the superficial benefit – is that this causes these companies to seem smaller (in Market Cap or Enterprise Value) than they really are.

Contrast this with profitable companies which are forced to include these options and RSUs in their diluted earnings per share – which will show the lower EPS number – because this assumes that option holders will exercise to “get” those earnings and dilute the shares.

While these two points are superficial because investors have to focus on real profitability (even if it means modeling years out) and real diluted market value, I think it does have an effect at least on the margin.

What I really think is happening here, is that investors who are chasing performance especially in “risk-on” environments are bidding up the non profitable names.

These companies typically have higher Betas. Why? Because of the same uncertainty that works against them in “risk-off” times.

As I wrote in the $KING post, uncertainty is bad because it means a higher discount rate. (In the case of $KING – the likelihood of future hits are very uncertain, so that higher discount rate causes lower current fair values for those future expected cash flows.) The uncertainty can however work for these companies valuation as well.

A bond, because its cash flows are certain, no matter how low the discount rate will be – say it somehow has no risks, no uncertainty on timing , no reinvestment risk etc. still, you will never be able to get any higher cash flows than what you are currently expecting. Likewise with those stable and easy to model equities, yes, those cash flows warrant a lower discount rate, hence increasing their current value, but the higher potential upside from higher future cash flows and earnings are a much lower probability.

The higher risk equities however, including many currently unprofitable ones, while they do deserve higher discount rates to discount the current expected cash flows, they do have the benefit of being more likely to achieve even higher cash flows than investors are currently discounting.

Bottom line is, uncertainty is a form of leverage, so when markets are in a “risk-on” mode – investors bid up non profitable companies to use the leverage in their favor. When the markets switch to “risk-off” though, investors run pretty quickly to de-lever from uncertainties.

- Aron

This entry was posted in General and tagged , , . Bookmark the permalink.

One Response to Uncertainty, another source of leverage.

  1. Enis says:

    Very nice post Aron, well done

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>