Valuing penny shares that don't make any money
David Thornton outlines some things to think about when valuing a company that has never made a profit and may never have made a sale.
In Red Hot Penny Shares I tip shares in three types of company. In each case I am looking for a low nominal share price, and the chance of high returns. The opportunities that I am looking for come under three headings: small but established companies that are growing fast; recovery stocks; and young companies that have yet to make a profit.
Once a company is making profits we can start to assess it using the financial ratios you might use to value larger companies. This collection of videos explains the main financial ratios. And if a company has made profits in the past, but a sticky patch has brought the share price down to a low level, we again have historic figures to work with. By making assumptions about sales and profit margins and debt levels we can judge whether or not this company, and its share price, is likely to recover.
Much the hardest type of company to analyse, though, is the company that has never made a profit and may never have made a sale. Since one of the purposes of the stock market is to provide a means for young companies to raise the capital that they need to get going, there are plenty that answer to this description amongst the penny shares on the Aim market. They have a bright idea and their founders have high hopes. They could be doing anything from drilling for oil, to making artificial skin or turning household rubbish into compost. How can we judge which are likely to succeed and which will fail?
a) What is the product?
The first thing to do is to really understand the product. This is not always easy, but whenever I meet the director of one of these companies I always ask them to explain what it is that their company is actually offering. If I cannot understand it, or if I cannot see a market for it, then I certainly would not invest in the business.
b) Where is the competition?
The wonder of capitalism is that it provides an incentive, in the form of profit, to any entrepreneur who can come up with something that we need or want. What this also means though is that if there is a need for, say, alternative forms of energy there will be hundreds of inventors and business people scurrying around trying to find them. In my experience it is very unlikely that a company will have no competition; it may have a lead over its competitors, it may have a product that is superior to others, it may have patented its products, but the chances are that somebody out there will be trying to supply the same market. It is not easy to check out the competition, but you should at least try a quick trawl around the internet is not difficult.
c) Is it worth it?
There are some great ideas out there and some great products, but if nobody will buy them they are worthless. You need to know how much the company proposes to charge for the product, and who it thinks will buy it. To give an example, I have encountered many companies that have come up with innovations in the field of medicine, but when they try to sell them to the bureaucratic, cash-strapped NHS, they get nowhere.
d) How big can it be?
I like to find a product that can conquer the world! Classic examples are McDonald's and Google. If a young company is going to become a really large one, it will have to make large sales and profits. And it cannot do that by selling croquet hoops. I look for a product that can have universal appeal and repeat sales. Another Coca Cola would be ideal!
e) Can it be profitable?
Every company needs to have a business model. This covers prices, methods of payment (eg outright sales vs leasing), sales, variable costs (which rise and fall with sales volumes) and fixed costs (which do not). When a company is starting out it will certainly be incurring costs before it is making any sales, but there must be a business model which will turn a loss into a profit at some stage in the future. Essentially, the revenue from sales must at some future point rise above the costs of running the company, or the company will be worthless. Is this realistic? What must the sales be in order to cover all the costs?
f) How long will it take?
If there is one thing that trips up young companies more than any other it is the time taken to reach the promised land of profit. However long a company's management tells you this will take, my advice is to double it. All sorts of things can slow progress: research and development into new products can hit barriers; small companies can often find that large potential customers supermarkets, big industrial companies or the government are not in anything like so much of a hurry as they would wish; new products have to be perfected, they have to be tested. They have to be demonstrated and introduced at trade fairs. They have to be sold to wary customers. It just takes a long time.
g) Will the money run out?
More often than not when young companies first come to the stock market they do so in order to raise the money they need to commercialise their idea. By looking at their accounts you can get a rough idea of how much it is costing them to run the company.
Suppose it is £1m per year. So if they raise £3m from new shareholders this is enough to run the company for three years, even if it never makes a penny of revenue. The problem comes if the end of this three-year period is in sight and there is no sign of any revenue. Given what I said in the previous paragraph, this happens all too often. If investors can see that a company is running out of cash, they will not buy the shares. The share price will fall, and, if the company is to survive, it must go cap in hand to the City and beg for more funds at whatever price it can get them. This is a very bad scenario for the share price.
h) Do you believe in the people?
Warren Buffett gets quoted a lot by investors. One of his famous observations is that if a management with a good reputation goes into a bad business, it is the reputation of the business that remains intact. This is not to say that management doesn't matter; in fact Buffett places huge emphasis on the quality of the managers who run his companies. Rather it advises you to avoid being seduced by talented or plausible managers who are in a bad industry. Ideally you want to find a good business which is being run by equally good people.
New companies are usually established by one of two types: young and ambitious people with a good idea, or those who have already had a career in an industry but combine a desire to run their own show with a belief that they know a better way of doing things. Either can be successful. But in my experience the former can be a bit nave. Things do not happen as fast as they expect. The latter understand the ups and downs of business life, know their own industry inside out, have valuable connections, and tend to be better at managing the expectations of the City. Often the young, thrusting entrepreneur who is supported by an experienced board of directors is the best combination.
In conclusion, putting a value on the shares of new companies is very tricky indeed. With few figures to play with, it really becomes a matter of faith in the product and the people behind it. What is crucial is not to get in too early if you have missed the initial surge of enthusiasm for the concept. It can take several years before a great idea becomes a product that is selling. Those years can be very frustrating both for the people in the business and for investors holding the shares. So the trick is to wait. Let others finance the development spending, the initial marketing, the recruitment of staff and premises. Then, when and if the product really starts to sell in earnest, join the fun!
In Red Hot Penny Shares, the place to find growth companies on the stock market, I run a virtual portfolio for readers. You can get access to this portfolio here .