This may sound like a bizarre statement but you only need to look at the recent Snap IPO to see that there can be significant demand for loss-making companies. At this moment in time nobody really knows when SnapChat will move into profit (if ever) but with large revenues, a growing customer base and potential for the future, the sky really is the limit. Well, in reality nobody really knows how far the company can go therefore any statements or projections can be supported to some extent. So, why do loss-making companies have the greatest profit potential?
Jam tomorrow
Over the years we have seen an array of social media companies come to the stock market on ratings which value the company’s in the tens of billions of dollars. We have seen Twitter, Facebook and now SnapChat to name just a small selection. All these companies came to the stock market as loss-making ventures and while Facebook is by far the most profitable this was not always the case. The companies were able to come to the market on relatively high valuations and, because they were loss-making, it was impossible to value them using traditional measurements and they always promised “jam tomorrow”.
In many ways these type of shares are a barometer of investor confidence and investor sentiment at any given time. When the markets are flying high investors are not concerned about loss-making companies instead preferring to look at the long-term when the profits will begin to roll in. When markets are in trouble, safe havens are the name of the day and this is when you see technology shares sold off – often with dramatic impact.
Moving into profit is dangerous
When a company is loss-making, as we touched on above, the traditional valuation methods we use today are irrelevant. True, we can look at revenue growth, activity amongst members and advertising income but with some of these larger technology companies there are huge losses in the early days. The only time we can use traditional valuation methods is when a company moves into profit which in theory can be the most dangerous time of its development. Indeed, in years gone by we have seen share prices re-rated on the downside because they moved from significant losses to profitability.
It may seem bizarre to suggest that the switch from significant losses to a small profit is a dangerous time but this puts more pressure on the company to deliver. All of a sudden investors are able to value the shares on a price-earnings ratio and even if this is expectations three, four or five years down the line, it can put a cap on the share price. These are the times we can often see a wild swing in share prices if there is even the slightest bit of disappointment or slowing of the growth rate.
Get in, get out and take a profit
The key to investing in early stage technology companies, as one example of often loss-making companies, is to get in early, sell the dream to other investors and take a profit before that all-important switch to profitability. After this point traditional valuation methods can come into play and even the slightest disappointment in forecast growth rates can have a detrimental impact on the share price. Selling the dream is easy, delivering results is often the hard part!