Price to Equity Ratio Continued: "Company that I like is not profitable"
In a prior post I reviewed the P/E ratio and offered an adjustment for growth. At that time, PE ratio of S&P 500 was 37 which is very high by historical standards. Now, at 39, it is even higher. Remember, for the value investor, lower P/E is better. We then pondered what gives and decided that growth adjusted PE, the PEG, may be the key performance indicator that is driving the market. We showed that a company with 37 PE and 22% earnings growth may be just as good as or better than a company with 18 PE and only 6% earnings growth. Growth matters!
In this post I want to go one step further and try to explain how we may look at a growing company which is still not profitable. These are typically innovative companies with high hopes and a story. Are Value Investors Precluded from Investing in these companies, or can we construct a value-based argument for these? VC’s do this all the time. They are in the business of high risk and high return.
We are looking for companies with high revenue growth but still negative earnings.
I looked for (in altadata.io financial statement data) companies with negative earnings and selected some familiar names among them which I may like (but the data will tell): Disney, Dominion Energy, AT&T, Palantir, Twitter, and of course, GameStop!
I am looking for companies with revenue growth. Why? Typically, expenses will grow slower than revenue and eventually these companies will become profitable. Typically! Only Twitter and Palantir showed revenue growth from 2019 to 2020. I pick these two.
The next key ingredient is to find a benchmark. Picking the right benchmark can turn into a research project. For illustration purposes, I picked Facebook. Some of the activities that Facebook is engaged in vaguely resemble Palantir and Twitter, hence let’s go with this for now.
In two years, even based on the Growth Adjusted PE ratio, Twitter does not quite measure up in comparison. But we made huge assumptions to reach this conclusion:
The recent, somewhat low, growth rate of the company (7.4%) will continue.
Same market cap in two years. Again, a big assumption, but that is OK. We are buying the company now and if the growth continues there will be other buyers at a higher market cap.
The company can achieve the same net margin (33%) as the benchmark. Some people that really like Twitter may think this is a conservative assumption.
Let us look at Palantir:
Palantir measures up somewhat better, but again, we assumed the high growth rate can continue. If it does, the growth adjusted PE ratio of Palantir may be even better than the benchmark.
What should we conclude from this? It all comes down to three things:
- Revenue growth. The main difference between the two companies is their growth rate.
- Profitability. We assume that eventually the companies can be as profitable as the benchmark.
- Last, but not least, a sustainable story that I like.
We have been in a bull market for more than a year now… Good luck.
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