Basically, businesses are beset with a host of risks every day. One needs to understand that negative earnings or losses can be caused by temporary (short-term or medium-term) factors or permanent (long-term) difficulties.
Valuing a loss-making company can be a seriously tricky affair. It is even more difficult to value a company with negative earnings or abnormally low earnings than a company with positive earnings. Actually, the valuation of loss-making companies is based on expectations, rather than fundamental valuations.
An investor can value any business using simple approaches regardless of the company’s current financial performance. The company’s business value depends on the future business prospects. For a company that is going to be in the business in the foreseeable future, there are three main ways to value it: Market approach, asset approach and income approach.
In market approach, investors need to identify comparable companies from the same industry, similar business and markets. The next step is to identify a suitable multiple to be used. Since price-to-earnings (P/E) ratios cannot be used to value unprofitable companies, an investor can use discounted cash flow (DCF) or relative valuation. The discounting to present value is done using the cost of capital of the company. DCF analysis works by projecting a company’s future free cash flows (FCFs) and then discounting these using an appropriate discount rate – usually the company’s weighted average cost of capital – to generate an estimate of the company’s present value.
Relative valuation uses comparable valuations that are based on multiples such as enterprise value-to-Ebitda and price-to-sales. Other multiples such as the price-to-shares ratio, or price to sales can also be used in certain cases. In another approach, we can check the net asset value (NAV). It is calculated simply as the fair value of the asset of a business less the external liabilities owed. The ultimate goal is to determine fair value, especially of assets since fair value may differ significantly from acquisition value (for non-depreciating assets) and recorded value (for depreciating assets).
It is important to remember that the goal of valuing a loss-making company is to determine its ‘worth’. The company’s valuation should justify one investment decision. A well-established company may command considerable goodwill, despite the current slide in profitability.
