Negative Earnings: Why they are a problem
• In the valuations that we have looked at so far, we have had
positive earnings in the base year to which we could apply
growth rates to get expected earnings in future periods.
• When earnings are negative, you cannot start with that
number in the base year and expect to grow yourself out of
the problem.
• The key to valuation, when earnings are negative, is to work
with the numbers until the earnings become positive. Exactly
how this is done will depend upon why the earnings are
negative in the first place.
• In fact, this applies even if your earnings are positive but
185
lower than normal.
A Framework for Dealing with Negative
Earnings
A Framework for Analyzing Companies with Negative or Abnormally Low Earnings
Why are the earnings negative or abnormally low?
Temporary
Problems
Cyclicality:
Eg. Auto firm
in recession
Structural
Problems: Eg.
Cable co. with high
infrastruccture
investments.
Leverage
Problems: Eg.
An otherwise
healthy firm with
too much debt.
Long-term
Operating
Problems: Eg. A firm
with significant
production or cost
problems.
Normalize Earnings
If firm’s size has not
changed significantly
over time
Average Dollar
Earnings (Net
Income if Equity and
EBIT if Firm made by
the firm over time
If firm’s size has changed
over time
Use firm’s average ROE (if
valuing equity) or average
ROC (if valuing firm) on
current BV of equity (if ROE) or
current BV of capital (if ROC)
Value the firm by doing detailed cash
flow forecasts starting with revenues
and reduce or eliminate the problem
over time.:
(a) If prob lem is structural: Target for
operating margins of stable firms in the
sector.
(b) If prob lem is leverage: Target for a
debt ratio that the firm will be
comfortable with by end of period,
which could be its own optimal or the
industry average.
(c) If prob lem is operating: Target for
an industry-average operating margin. 186
Amazon.com: The Facts
• Amazon.com retails books online. It started operations in 1995
and increased revenues from $0.5 million to $ 15.7 million in
1996. In the first 3 quarters of 1997 it had revenues of $ 82
millions and expects to end 1997 with revenues of $ 150
million.
• The company has never been profitable. It lost $ 5.8 million in
1996 and expects to lose 5 times as much in 1997.
• Its earnings before interest and taxes for 1997 are expected to
be – $ 30 million.
187
Amazon.com: The Facts
• It did an initial public offering in May 1997 at $ 18 per share.
There are 23.859 million shares outstanding. The firm has no
debt outstanding.
• The firm is expected to have depreciation of $ 2.50 million and
capital expenditures of $ 7.5 million in 1997.
188
Amazon.com: Model Discussion
• In valuing Amazon, there are several factors to consider.
– The firm has negative earnings and EBIT currently. The
negative earnings are not due to poor management or an
abnormal year, but can be attributed to the fact that this firm
is still young, has made significant investments in
establishing a presence in the web retail market and has low
revenues. Furthermore, there is not much financial history to
base the valuation on.
189
Amazon.com: Model Discussion
• In valuing Amazon, there are several factors to consider.
– There are more established book sellers (like Barnes and
Noble, Border’s books) who are publicly traded, but they sell
through traditional outlets. These book sellers have some
debt (about 15%) in their capital structure and operating
margins of approximately 8%. We will assume that
Amazon.com will move towards these averages in the long
term.
190
Amazon.com: Model Discussion
• In valuing Amazon, there are several factors to consider.
– There are Internet based firms (Netscape, Yahoo..) which
are publicly traded. Though they have not been listed very
long, the average beta for these firms is 1.80. Amazon is
assumed to have a similar beta.
To value Amazon, we will use a FCFF Model, with year-specific
margins
191
Amazon.com: Inputs
Year
1
2
3
4
5
6
7
8
9
10
Growth in
Revenues
150.00%
100.00%
75.00%
50.00%
40.00%
33.20%
26.40%
19.60%
12.80%
6.00%
COGS as
% of Rev
120%
110%
105%
100%
98%
97%
96%
95%
94%
92%
Growth in
Cap Ex
100%
75%
50%
40%
33%
26%
20%
13%
6%
6%
Deprecn
150%
100%
75%
50%
40%
33%
26%
20%
13%
6%
WC as % of
Revenues
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
192
Amazon.com: Explaining the
Inputs
• Revenue growth is anticipated to remain strong but become
lower (in percentage terms) as the firm becomes larger. In
steady state, revenue is expected to grow 6%.
• The operating margin in 1998 will be similar to the margin in
1997 (i.e., -20%). Over the next 10 years, the margin will
approach the average for book retailers (Barnes and Noble,
Border Books)
• Cap Ex will lead revenue growth by one year. (Next year’s
revenue growth will be this year’s cap ex growth). Depreciation
will grow with revenues.
193
Amazon.com: Explaining the
Inputs
• Non-cash working capital as a percent of revenues will be 5%.
This is lower than the average for other book retailers (about 810%), because we assume that a web-based book seller can
maintain lower inventories.
194
Amazon.com: Cash Flows
1
2
3
4
5
6
7
8
9
10
Terminal Year
Revenues
$375.00
$750.00
$1,312.50
$1,968.75
$2,756.25
$3,671.33
$4,640.55
$5,550.10
$6,260.52
$6,636.15
$7,034.32
- COGS
$450.00
$825.00
$1,378.13
$1,968.75
$2,701.13
$3,561.19
$4,454.93
$5,328.10
$5,947.49
$6,237.98
$6,471.57
$6.25
$12.50
$21.88
$32.81
$45.94
$61.19
$77.34
$92.50
$104.34
$110.60
$117.24
EBIT
($81.25)
($87.50)
($87.50)
($32.81)
$9.19
$48.95
$108.28
$129.50
$208.68
$287.57
$445.51
- EBIT*t
($29.25)
($31.50)
($31.50)
($11.81)
$3.31
$17.62
$38.98
$46.62
$75.13
$103.52
$160.38
EBIT (1-t)
($52.00)
($56.00)
($56.00)
($21.00)
$5.88
$31.33
$69.30
$82.88
$133.56
$184.04
$285.12
+ Depreciation
$6.25
$12.50
$21.88
$32.81
$45.94
$61.19
$77.34
$92.50
$104.34
$110.60
$117.24
- Capital Spending
$15.00
$26.25
$39.38
$55.13
$73.43
$92.81
$111.00
$125.21
$132.72
$140.69
$128.96
- Chg. Working Capital
$11.25
$18.75
$28.13
$32.81
$39.38
$45.75
$48.46
$45.48
$35.52
$18.78
$19.91
Free CF to Firm
($72.00)
($88.50)
($101.63)
($76.13)
($60.98)
($46.05)
($12.82)
$4.70
$69.66
$135.18
$253.49
- Depreciation
195
Amazon.com: Costs of Capital
and Terminal Value
• Cost of Capital for next 10 years
– Cost of Equity =
15.90%
– Equity/(Debt+Equity ) =
100.00%
– Cost of Capital =
15.90%
• Cost of Capital after year 10:
– Cost of Equity in Stable Phase =
11.50%
– Equity/ (Equity + Debt) =
85.00%
– AT Cost of Debt in Stable Phase = 8% (1-.36) = 5.12%
– Debt/ (Equity + Debt) =
15.00%
– Cost of Capital in Stable Phase =
10.54%
196
Amazon.com: Costs of Capital
and Terminal Value
• Terminal Value of Firm
– Value of Firm = 253.49/(.1054-.06) = $5,580 million
197
Amazon.com: Valuation
Year
1
2
3
4
5
6
7
8
9
10
FCFF
($72)
($89)
($102)
($76)
($61)
($46)
($13)
$5
$70
$135
Terminal Value PV
($62)
($66)
($65)
($42)
($29)
($19)
($5)
$1
$18
$5,580
$1,307
198
Amazon.com: Valuation
Value of Firm
- Value of Debt
Value of Equity
Value per Share =
$1,038
$0
$1,038
$43.52
199
Amazon.com: The Value Drivers
Firm Value and Opera ting Ma rgin
1600
1400
1200
Value of Equity
1000
800
600
400
200
0
5%
6%
7%
8%
Pre-tax Operating Margin
9%
10%
200
Amazon.com: The Value Drivers
Compounded Revenue Growth and Firm Value
3000
2500
2000
Firm Value
1500
1000
500
0
10%
20%
30%
40%
50%
60%
-500
Compounded Revenue Growth (next 10 years)
201
Amazon.com: The Value
Drivers
Working Capital and Value
1400
1200
Value of Equity
1000
800
600
400
200
0
1%
2%
3%
4%
5%
6%
WC as % of Revenues
7%
8%
9%
202
10%