When investors don’t care about profits
I made the statement in a recent article that “value” does not always follow profitability. And, it was to some degree motivated by a recent article I read by Fred Wilson, a VC and blogger who I follow (and highly recommend). He recently posted an article on profitability which criticized to some degree the business model employed by many internet startups which typically involves the scaling of headcount and resources in the hopes of revenue growth without nary a thought for the bottom line. While this is obviously not a strategy that works in the long run, I was surprised that a VC would write so negatively on this . Yes, the ultimate goal for a business is to be profitable and generate cash for its shareholders. I understand that in this economy liquidity in the form of credit, follow on investments, and much less lucrative exits – IPOs, acquisitions, etc. – are hard to find. As a result, cash is king and profitability is a significant concern for investors. Let’s not forget, however, that investment return is built on more than just profitability:
Investment Return = Dividend + Change in Valuation * Change in Profitability
The dividend portion of this formula is simple, as mentioned in my last post on capital allocation decisions, management of a business can always decide to return any profits made to the investors.
The next two portions of the investment return formula are less concrete. Growth in profitability typically results in increasing value in your investment. For example, whenever a business reports EPS growth, we usually see a corresponding increases in share value. Unless, of course, if marke valuations already anticipate said growth or if recessionary pressures are decreasing risk appetite and driving down valuations regardless of profit success. This has happened to many good companies during the current recession.
For mature businesses, the likelihood of multiple expansion or outsized earnings growth is generally slower and less relied upon for returns, but, for growth businesses like the ones VCs typically invest in, it is this part of the equation which generates the bulk of returns. This is also true of growth businesses – retail, tech, alternative energy – that average investors can access in the public markets. Investments by a business’ management in head count and other overhead may hurt profitability in the short run, but they create a platform for creating scale in the business. As Fred argues in his article, profitability can be attacked through the management of costs and typically it can be done quickly whenever management decides it needs to focus on this side of the equation. That is why a lot of startups, like Facebook and Google, focus instead on scaling revenue and service offerings. Google, already dominant in search, continues to invest in new ventures and products and continually increasing its revenue (and ultimately it’s profit) potential. Yes, some companies like Craigslist, are able to handle operating margin in excess of 90% through a super lean cost structure, but they offer just one specialized product and, while organic growth is abundant now, they will eventually plateau and so will valuation.
Don’t start buying into Dot-Bombs just yet
Am I arguing a 90s-tech-bubble style “paradigm shift”? I admit that there’s a real slippery slope in the arguments laid out above. If you believe valuation multiple expansion and likelihood of growth in profitability can be derived simply from metrics like revenue growth, then why not completely non-cash metrics like users, eyeballs, and hits? I would never recommend going this far in trying to anticipate future performance of your investments. But, this is where I believe due diligence and familiarity with the industries you invest in are necessary and provide an advantage when investing in growth businesses. Asking the right questions of and demanding the right results from management is critical to monitoring growth businesses during the time that they focus more on revenue growth than profitability. My focus would be on the following:
- In the event of a downturn or the maturation of the market, could the business quickly cut excess capacity and operate profitably?
- How defensible is the current revenue level under a leaner cost structure?
- How quickly are new investments expected to payback?
The answers to these questions are typically addressed during earnings calls or in quarterly and annual reporting. Analysis of historical return on invested capital both for the business as a whole and on a project by project basis can help you to determine how much to expect as return for marginal spending and at what point you should expect to see results hit the bottom line (usually after the valuation of your investment has already appreciated).
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