Valuation of Negative Earning Firms

Valuation of Negative Earning Firms

Faisal Usmani (Aligarh Muslim University, India), Atif Ghayas (Aligarh Muslim University, India) and Mohd Sarim (Aligarh Muslim University, India)
Copyright: © 2020 |Pages: 11
DOI: 10.4018/978-1-7998-1086-5.ch007

Abstract

This book mostly concentrates on firms with positive earnings, but this chapter focuses on the negative earnings firms or firms with very low earnings. It is easier to value a positive earning firm than a company with negative earnings. Analyzing negative earning firms has always created problems for researchers and analysts. In case of a negative earning firm, growth rates cannot be predicted or used in the valuation of firms. When current income of the firms is negative, growth rate will make it more negative. Tax computation becomes more complicated and the Going Concern Assumption does not apply properly. Authors start with complications in valuing negative earning firms, discuss the causes of negative earnings, and whether the problem is short-term, long-term, or cyclical in nature. Finally, authors provide the appropriate valuation technique for each case.
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Introduction

Start-ups and early-stage companies with negative earnings, and experiencing seasonal or structural financial problems, do not allow use of traditional valuation concepts as it is unclear how and when the company will produce positive cash flow for their investors. To value such companies, it is critically important to have a more in-depth analysis and understanding of external and internal forces that affect a firm’s ability to generate positive cash flow. It is quite clear, zero positive cash flow eventually equals no value! The dot-com bubble at the turn of 21st century clearly demonstrated that when the business hype finally ends, start-ups and early-stage companies must produce a financially successful business and revenue model that can generate cash flow.

Start-up and early-stage companies are generally valued on a prospective basis, with the underlying managerial assumption that the business model of the company being valued will eventually succeed (and hence, generate positive cash flow). As far as a firm is predicted to survive, negative profitability is, by definition, a transitory state since investors have an abandonment option and will not allow losses to continue indefinitely (Jenkins, 2003). Therefore, this study elucidates the model of mean-reversion of profitability to reflect the expected future profitability of loss firms. That is in fact what investors are betting on, especially for a company like Uber.

One of the keys to success and to achieving the valuation placed on a start-up and early-stage companies is the ability to raise sufficient capital to cover the operating losses until profitability is reached. One of the most significant issues in valuing a start-up or an early stage company is sufficiency of capital to achieve the business plan. Undercapitalized start-ups and early-stage companies by their nature are doomed and the valuations placed on them are subject to scrutiny. (Joos and Plesko, 2005).

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