1. Valuing firms with no Earnings1 Valuing Companies with Negative Earnings Many start-ups have losses or very small profits for the initial years due to high marketing or R&D expenses. These companies grow at very high rates. –Successful companies may increase sales by 100 times in the first few years. Multiples Valuations – P/E ratios are absurd if there is no earnings to value. –Using values of these ratios 3 or 5 years out does not capture the fact that growth will continue for possibly 10 or 15 years.

2. Valuing firms with no Earnings2 Valuing Companies with Negative Earnings Two approaches to valuation 1.Change the Accounting 2.Work Backwards 1.Accounting Standards require that R&D is expensed immediately; however, firms benefit from R&D for many years to come –Capitalize R&D similar to how capital expenditures (purchases of fixed assets) are capitalized 2.Determine the FCF at stabilization and work backwards to get a stream of FCF to value

3. Valuing firms with no Earnings3 Changing the Accounting Currently R&D is expensed immediately –Each year Net Income is reduced by 100% of R&D Amgen 1998: Net Income 644.3 and R&D 630.8. –Each year Retained Earnings is reduced by 100% of R&D Amgen 1998: No Dividend so RE reduced same as above. If R&D was capitalized (assuming 10 year amortization). –Income is reduced by 1/10 of this year’s R&D as well as 1/10 of the R&D of every year for the last 10 years. –This is similar to how capital expenditures (changes in fixed assets) are capitalized through depreciation. Book Equity would increase by the amount of unamortized R&D, i.e. there would be an intangible asset on the books.

4. Valuing firms with no Earnings4 Capitalizing R&D If you Capitalize R&D, –Income increase in the early years and decreases in the later years –Investing activities increase (still spend the $) –FCF is unchanged –Book Equity increases. So, Capitalizing R&D will change the equity and book value but not the FCF.

5. Valuing firms with no Earnings5 Use DCF The DCF method to valuing an assets is almost always the best alternative. The problem is that for some firms there is no CF to D Solution –Start at a point in the future when the firm has CF

6. Valuing firms with no Earnings6 Valuing the no CF firm Consider Amazon –In four years, Amazon has built an over 10 million customer base and expanded its offerings. –Amazon has invested heavily in its brand-name and most people are familiar with the name –The firm has a high market capitalization Currently $ 9.127 billion About a year ago it was $ 25 billion –However, the firm has turned little if any profit Amazon lies at the heart of the debate of how to value internet and start-up firms.

7. Valuing firms with no Earnings7 Start from the Future Trying to determine how a firm is going to go from negative profit and cash flow to a FCF high enough to justify its market capitalization is perplexing Solution: Approach the problem from another angle –Think about the firm and its industry – When do you think it will likely begin to stabilize. For the internet companies this will likely be 10 or 15 years from now since this is a very new industry

8. Valuing firms with no Earnings8 Amazon – the next Walmart? Assume (optimistically) that Amazon continues to be the market leader and takes a significant percentage of the book and music market share. –If the company takes 13-12% of the market share by 2010, it would have revenues of about $60 billion. –The average operating margin (operating cashflow / sales) in this industry is about 11%. –So the optimistic scenario may be that Amazon has: $60 billion in revenues $7 billion in profit Growth will be 15% for 15 years after 2010 and stabilize at 5.5% This results in a value of $ 38 billion (discount rate of 15%)

9. Valuing firms with no Earnings9 Scenario Analysis The previous analysis is not a credible forecast but a description of what could happen in a best case scenario. We should also forecast a likely and worst case scenario –Likely: 8-10% of the market share - $41 billion in revenue, 8% margin – resulting in a value of $19 billion –Worst Case: 5 – 6% of the market share - $17 billion in revenue, 7% margin – resulting in a value of $7 billion

10. Valuing firms with no Earnings10 Scenario Analysis There is much uncertainty with this type of analysis and we need to account for that uncertainty by weighting the ultimate value by its probability of occurring. –Best Case: Value = $38 billion and probability = 30% –Likely Case: Value = $19 billion and probability = 40% –Worst Case: Value = $7 billion and probability = 30% –Expected Value = $ 21 billion Scenario Analysis if very helpful in this type of valuation because we are estimating far into the future – which increases the uncertainty –Note: Each scenario pertains to what Amazon will become. We are fairly certain of the growth in 2010 and beyond. However, if we were not, we could alter that as well.

11. Valuing firms with no Earnings11 Impact of changing Expectations Changes to our probabilities results in dramatic changes in values. –If you weight the worst case 70%, the likely case 20% and the best case 10% to reflect the recent downturn, the value drops to $ 12.5 billion

12. Valuing firms with no Earnings12 From Probability to Reality The last step is to determine how Amazon is going to go from a negative earnings and cash flow firm to one that may earn as much as $60 billion with a $7 billion operating profit. –For internet companies, customer value analysis is useful Five factors driving customer value analysis –Average revenue per customer –Total number of customers –Cost of getting new customers –Contribution Margin per customer – operating profit per customer –Customer churn rate – proportion of customers lost each year.

13. Valuing firms with no Earnings13 From Probability to Reality You should compare these numbers now to what they must be to get each scenario. To get from negative cash flow to $60 billion dollars, each of these numbers must be strong and improving over time. –Amazon must continue to build its new customer base without losing old customers. –It must increase the sales to each customer while keeping profits down.

14. Valuing firms with no Earnings14 Risk and Uncertainty It is possible that Amazon will realize the best case scenario and its value will be $39 billion. –If this is the case, it will appear that the market underestimated Amazon’s ability. This is not necessarily true. The market simply factored in uncertainty As we are seeing recently, not all of the internet companies will make it. –After the invention of the automobile, the US market was flooded with auto manufacturers. Today, only 3 are left. –WSJ online now has a link to layoffs and shutdowns by dot.coms. To date, 96 firms have had major layoffs or shutdown.

15. Valuing firms with no Earnings15 Amazon Stock Price for one year