One of the most frequent advisories that I give on this site is:
“At this price and at this time, I do not think that a Confident Investor can confidently invest in this stock. It is not possible to confidently invest in a company that is not currently profitable.”
I have probably written that line 150 times on this site.
In addition, on Twitter I will get direct messages almost daily asking about a company that is not able to be run profitably. My replies vary in their words, but they always could be summed up with
“Sell this stock as fast as you can and find a profitable company that you trust. Here is a list of companies to consider: http://ow.ly/ckflM”
Regular readers of my opinions on investing know that I am very consistent in my advice not to invest in companies that are currently unprofitable. I do not limit that advice to just being unprofitable for a year but also to the latest quarter. I thought I would share a few thoughts on the reasoning behind this advice.
Due to the length of my thoughts on this subject, I need to break this topic into a couple posts. The high-level topics are:
- How do you evaluate an unprofitable company?
- Unprofitable companies can do stupid things
- Did management of a company plan to be unprofitable? No? Doesn’t that mean they are failing?
- Why invest in companies that are not profitable if you can invest in ones that are profitable?
- Is there ever an appropriate time to invest in unprofitable companies?
If you want to be notified when I post about avoiding unprofitable companies, there are several straightforward ways to do this. You can subscribe to my feed in your news reader. You can also sign up for my weekly newsletter which will give you the articles for the week. Finally, you can subscribe to my Twitter account @ConfidentInvest.
I will explore the first topic of the list now, the rest will be in future posts.
How do you evaluate an unprofitable company?
One of the most standard methods of comparing the performance of an investment is the P/E ratio (the price/earnings ratio). While it is foolish to compare the P/E for dissimilar companies (e.g. Ford [stckqut]F[/stckqut] with Google [stckqut]GOOG[/stckqut]) it is entirely relevant to compare the P/E for competitors (e.g. Apple [stckqut]AAPL[/stckqut] with Dell [stckqut]DELL[/stckqut]). Comparing P/E between competitors should not give the investor extreme confidence that one company is better than the other, but it is a consideration. In an unprofitable company, P/E will be a negative number – how do you compare that to its profitable peers?
Another tool for developing an appropriate price is to look at the EPS (Earnings Per Share). Once again, we have a problem with unprofitable companies as this will be a negative number. Comparing a negative EPS with its profitable peer group is never going to result in a situation where we can be a Confident Investor.
We can also calculate the best price for a company based on its Free Cash Flow. However, that calculation depends on profit! This is problematic for getting a clear understanding of an unprofitable company.
Another tool is to use the growth of a company to create a P/E equivalent. If the company used to be profitable and now is not, then the growth of the profit is obviously a negative number. Using this technique, a Confident Investor has to factor the negative growth of profit into any other growth number e.g. Revenue or Stock Price. Typically, we assume that the P/E is approximately equivalent to growth e.g. growth of stock price is 30% so the P/E is 30. This is a rule-of-thumb equivalency and is fraught with danger and inaccuracies.