Speculative Companies: How to Analyze (If You Must)

Speculative companies should be evaluated on cash, burn rate, probability of success, size of potential market and margins at maturity.

Speculative Companies: How to Analyze (If You Must)

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:

  • Cash
  • 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



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.