Speculative companies should be evaluated on cash, burn rate, probability of success, size of potential market and margins at maturity.
I rarely buy speculative companies, but it is an interesting question as to how speculative companies like Amazon.com, Inc. (NASDAQ:AMZN), Google Inc (NASDAQ:GOOG), or a biotech firm should be valued. Speculative companies are like options; they often end with no value, and occasionally end with a large value.
Here are my five points:
- Burn rate
- Probability of success
- Size of potential market, and
- Margins at maturity.
Cash and burn rate tell you how long the company has to play before it fails. If a company is spending cash in an effort to produce a profitable business, how long can it do so until it runs out of cash?
That plays into the probability of success — more time means a higher probability, mostly, but desperation can aid success. Other aspects on probability of success include the competition, novelty/reliability of the science, etc.
If the strategy does succeed, how large could the market be that is served, and how big could the margins be as part of an oligopoly?
But after all that, discount for the probability of failure, and discount the future earnings stream at 20%/year, because this is so uncertain.
As I said to colleagues at one firm I worked for in 2004, “Imagine Google gets 20% of the profits of the global advertising business 10 years out, and holds onto it? What would that be worth?”
It would be worth a lot, and Google has probably exceeded that profitability estimate, thus the high market valuation of Google. Give credit to people with clever ideas at the right time.
Anyway, be careful investing in speculative companies — this is an area where you will get more strikeouts than home runs. I tend to be a singles hitter in investing, but with a high average. But in the few cases where I look at a speculative company, this is how I do it.
By David Merkel, CFA of Aleph Blog