Earlier this week I received an email from a past participant of a senior leadership development program I ran for his company a few years ago.  The subject of the email read: “Confidential – Idea for
your Blog.”  As I am always looking for new and interesting material, I opened it right away.

Some of the most valuable companies in the world – the ones that we know as the darlings of Wall Street – have never made a profit.  Twitter, one of the most innovative and disruptive companies ever to be created (and one of my personal favorites), has lost $78 million, $635 million, $538 million, $450 million, and about $275 million in the last five years.  That is around $2 billion in negative net income during this time.  Yet as of today, Twitter has a market capitalization of about $12 billion. Only until recently has another darling, Amazon, turned a profit after years and years of losing billions of dollars.

Last week, I was facilitating a Business Acumen program for a very established company fighting off new emerging companies. The established company has been making a profit and paying a sizable dividend for years, yet their market cap is very low and their overall perception in their business markets and the financial markets is very stale.  One of the major questions that consistently comes up during these Business Acumen training workshops is about profitability and when should an emerging business make a profit?

Like many things in the world of finance and business, the answer is, “It depends.”

It depends on many things such as the long-term strategy, the goals of the investors, the cycle of technology, the cycle of incoming competitors, and many other factors.

It’s probably appropriate given the new US President’s rhetoric on imports to start with a brief story of the Japanese entry into the US car market in the late 1960’s and early 1970.  Up until that time, the US car market was dominated by US manufacturers and some “foreign” cars that were both common such as Volkswagen and exotic such as Rolls Royce.  The Japanese entry was much different; it was planned and it was strategic.  In 1972, the Honda Civic entered the US market with basically a motorcycle engine and a very low price.  The strategy was to capture market share and then over the long term build brand loyalty through quality, service, and unique marketing.  They executed flawlessly. 50 years later, Japanese brands such as Honda have their core brands such as the Accord – which is extremely profitable – and the Acura which is positioned as the luxury brand.  Unfortunately for Honda, Acura is easily beaten by Lexus (Toyota) and Infiniti (Nissan) in that luxury segment of the market.  But they are all, very, very profitable as a result of a long-term strategy.

Which brings us back some of the emerging disruptive technology companies of today and the answer to the question.

Emerging companies don’t have to make a profit for a long time as long as there is a potential of a profit.  The reason why a Twitter has a market cap of $12 billion is that the investors are “betting” that one day they will be profitable and be able to pay a dividend and increase even further the total shareholder return. 

As recently as the beginning of 2015, Amazon’s stock price was $290 a share. And that is around the time they were losing over $100 million in 2014.  When things started to change in terms of sustainable profitability in late 2015 and into 2016, the stock price rose dramatically to over $800 a share; the promise of the one-day-soon profitability finally came and it was a wonderful thing for shareholders.

These examples are good archetypes for understanding this complex issue.  Here are two important business acumen analysis tools to further explore the question of this blog:

1. What is the rate of revenue growth vs. expense growth? If Revenues are growing faster than expenses, then by default, there will be a point in time that the revenue is greater than expenses (which is a profit).
2. Does the company have at least 5 years of cash to pay for the losses and execute the strategy? By checking the balance sheet you can easily answer this question.

In summary, sometimes companies who lose money and have a high market cap make no sense.  It takes strong business acumen and analysis to figure out the reasons and embrace the impact.