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Step-by-Step Guide for Valuating a Non-Profitable Stock


Step-by-Step Guide for Valuating a Non-Profitable Stock

Investing in non-profitable stocks can be a daunting but potentially rewarding venture. While many investors gravitate towards established, profitable companies, there are valuable opportunities in emerging businesses that have yet to turn a profit.


However, valuing such stocks requires a different approach since traditional metrics like Price-to-Earnings (P/E) ratios may not be applicable.


In this article, we will explore various methods and factors to consider when valuating a non-profitable stock.


Before we dive deeper into the subject, I invite you to check my latest book, The Art of Investing. There, you can find many valuable insights to improve your investing performance.

The Art of Investing - ARTInvest - Artenie Alexandru

4 Key Factors for Understanding Non-Profitable Stocks


Before diving into valuation techniques, it's crucial to understand what non-profitable stocks are and why they can be attractive investments.


A non-profitable stock is one issued by a company that has not yet generated net income. Such companies are often in the growth phase, focusing on expanding their operations and market share rather than maximizing immediate profits.


While these stocks may appear riskier due to the absence of earnings, they can offer significant potential for capital appreciation if the company successfully executes its growth strategy.


Throughout this article, we will take the NIO stock as an example, which is not yet profitable at the moment of writing (September 2023). Please note that the purpose of this article is not the analysis of NIO stock itself. The scope is to present the valuation methods for a not yet profitable company. Everything NIO-related will be marketed in blue and Italics.


Let's go!


1. Evaluate the Business Model and Growth Potential

The first step in valuing a non-profitable stock is to assess the company's business model and growth potential. Ask yourself the following questions:

  • What is the company's core product or service?

NIO is a Chinese electric vehicle (EV) manufacturer, and its core product or service is the production and sale of electric vehicles. NIO primarily focuses on designing, manufacturing, and selling premium electric SUVs.

  • Is there a growing demand for this product or service in the market?

For NIO, the trend is clearly positive as the sales of Electric Vehicles rise year by year. Below is a chart of EV sales according to tridenstechnology.com, which also shows their market share.

EV sales by year
Electric Car Sales by Year. Source: tridenstechnology.com
  • Does the company have a competitive advantage or unique selling proposition?

There is indeed something unique about NIO. NIO is known for its innovative battery-swapping technology, which allows customers to exchange depleted batteries for fully charged ones at dedicated swapping stations. This approach addresses range anxiety and reduces charging time.


In addition, NIO introduced a Battery-as-a-Service (BaaS) model, allowing customers to purchase EVs without the battery and subscribe to a battery service plan. This provides flexibility and affordability for customers.

  • Is the company expanding its market reach or customer base?

Well, here I am not impressed. Although NIO increased its vehicle sales in 2023, that is completely outshined by other manufacturers, such as Volvo, BYD, and Tesla.

global ev sales by OEM
Global EV sales by OEM 2023 H1 vs 2022 H1. Source: EV-Volumes.com

These questions will help you gauge the company's viability and potential to eventually become profitable.


2. Analyze Revenue Growth and Income Trend

In the absence of profitability, revenue growth becomes a critical metric. Examine the company's historical revenue growth rates and assess whether they are sustainable. Look for consistent and accelerating revenue growth as a positive sign.


For NIO, we get here a good picture illustrating the increasing revenue growth over the years, according to their income statement.

NIO income statement
NIO Total Revenue. Source: Financials section, SeekingAlpha.com

However, the net income does not show signs of a positive trend. So does EBITDA, which makes me worry.

NIO Net Income
NIO Net Income. Source: Financials section on SeekingAlpha.com
NIO EBITDA
NIO EBITDA. Source: Financials section on SeekingAlpha.com

3. Study the Competitive Landscape

Investigate the competitive landscape to determine how the company compares to its peers. A company with a unique product or service, strong branding, or a disruptive business model may have an advantage over competitors.


I am afraid NIO is losing its market share judging on the statistics above. Even if the sales go up, many of the competitors are ahead of them. More on that later.


4. Review Management Team and Strategy

The management team plays a vital role in the success of a non-profitable company. Assess the qualifications and experience of the executives and their ability to execute the company's growth strategy.


The CEO, William Li, is heavily invested in the company as he owns 9.3% of the company, and he has been in the role for 5 and a half years. I would say that is some reasonable experience.


William Li started his career in the IT industry before transitioning to the automotive sector. He founded Bitauto Holdings Ltd., a leading provider of internet content and marketing services for China's automotive industry, before establishing NIO.


Unfortunately, there is not too much information about him.


Under William Li's leadership, NIO aims to revolutionize the electric vehicle market by offering high-performance electric SUVs, focusing on cutting-edge technology, and implementing a user-centric approach to mobility.


William Li has expressed ambitions for NIO to expand its presence beyond China, with plans for entering international markets such as Europe and the United States.


That was it with qualitative analysis; now let's look at some quantitative metrics.


3 Valuation Methods for Non-Profitable Stocks


Now that you have a better understanding of the company, let's delve into specific valuation methods tailored for non-profitable stocks:


1. Discounted Cash Flow (DCF) Analysis

DCF analysis estimates the present value of a company's future cash flows. For non-profitable stocks, you may need to make assumptions about when the company will become profitable and the magnitude of future cash flows. This method helps you determine the stock's intrinsic value based on your growth and profitability forecasts.


This is a very laborious exercise, but fortunately, we can use some platforms that do the calculation for us. I often use SimplyWallSt for this purpose.


NIO stock value
NIO Stock Value using DCF model. Source: SimplyWallSt

I like the amount of green color present in the above picture. According to SimplyWallSt's DCF calculation, the fair value of NIO is $14.45, which makes it significantly undervalued at its current price of $8.41.


This is a little bit surprising, considering they are not forecasted to become profitable not even until 2026, as per TradingView data. We will see that picture later.


2. Comparative Analysis

Comparative analysis involves comparing the non-profitable stock to similar, established companies in the same industry. Key metrics to consider include Price-to-Sales (P/S) ratios, Price-to-Book (P/B) ratios, and growth rates. If the non-profitable company has a lower valuation relative to its peers, it may be undervalued.


The P/S ratio compares a company's stock price to its revenue per share. It reflects how the market values each dollar of a company's sales.


The P/B ratio compares a company's stock price to its book value per share. Book value is essentially the net asset value of the company and is calculated by subtracting total liabilities from total assets.


I think it is quite easy to pick a different stock to compare with. That is Tesla. But let's extend the exercise and compare Nio's valuation metrics with Lucid Group (LCID) and XPeng (XPEV) as well. We will compile the comparative valuation table using SeekingAlpha.

NIO vs peers
NIO P/S and P/B vs peers. Source: Peers section on SeekingAlpha.com

Hmm...well well...


The NIO's P/S ratio is the lowest among the evaluated competitors. This means that we pay the least amount of money for a unit of sales. This looks good.


The P/B ratio is however not that shining, as it exceeds by far the ratios of LCID and XPEV. This means we have to pay more for NIO's book value per share compared to the other 2 companies. Still, it has a significant advantage over TSLA.


Quite controversial.


Let's look at growth rates. I am particularly interested in the earnings growth rates to understand how profitability is evolving.


Unfortunately, I was not able to find pre-compiled data, so I went through individual financial statements to gather the data.

NIO EPS vs Peers
NIO EPS vs Peers. Built by author based on data from financial statements

I don't like what I see. Nio is on a clear downtrend since 2020, as opposed to its peers.


3. Market Capitalization and Potential Market Share

Calculate the company's current market capitalization (share price multiplied by the number of outstanding shares). Then, estimate the potential market share the company could capture as it grows. This can provide a rough estimate of future market capitalization and, by extension, the stock's potential upside.


The Nio's market capitalization is $15.05B.


EV Market Forecast
EV Market Forecast. Source: marketsandmarkets.com

On the one hand, the current capitalization of Nio is very tiny, and on the other, the pie is getting bigger and bigger. Both indicate much room for potential growth for Nio, as we are far from market saturation. This means there is upside potential that the company will improve its earnings to justify a positive evolution of the stock price.


5 Risk Management Techniques and Due Diligence for Non-profitable Companies


Investing in non-profitable stocks carries inherent risks, and it's crucial to manage these risks effectively.


Let's see how.


1. Diversify Your Portfolio


Diversifying a portfolio is a critical strategy in investment. It involves spreading investments across various assets, industries, and geographic regions to manage risk. Avoiding over-concentration in one area helps cushion the impact of poor-performing investments and market volatility.


Effective diversification includes a mix of asset classes like stocks, bonds, real estate, and cash equivalents, each with different risk-return profiles. Additionally, it involves diversifying within asset classes by investing in various industries and internationally.


Overall, portfolio diversification is a prudent approach for investors, reducing risk while pursuing financial goals and enhancing long-term stability in an unpredictable financial landscape.


Let's see how to diversify in the case of NIO.


Sector: Consumer Discretionary.

You can diversify it with Consumer Staples, which is known for producing essential products like food, beverages, and household items. These products tend to be in demand regardless of economic conditions, making this sector less sensitive to economic downturns than Consumer Discretionary. Adding Consumer Staples can provide stability to your portfolio.


Asset Class: Stocks.

Bonds are often considered one of the primary asset classes to complement stocks. They are generally less volatile and provide income through regular interest payments. By adding bonds to your portfolio, you can reduce overall portfolio volatility, especially during market downturns.


Geographical Exposure: Asia.

Considering you are bullish on the EV industry, you might consider investing in a NIO's peer who is focusing outside Asia. A good example might be Tesla, which is selling primarily in the US.


Consider Exchange-Traded Funds (ETFs):

If you don't want to seek the needle in the stack, you can buy the complete stack. Some related ETFs to consider are KARS, IDRV, and DRIV.


2. Stay Informed


Staying informed about stock evolution is paramount for investors.

  • Financial news websites like Bloomberg and CNBC offer real-time news and expert analysis.

  • Mobile apps from brokerage firms like E*TRADE provide convenience and on-the-go tracking.

  • Company websites offer in-depth information, including financial reports.

  • Regulatory authorities like the SEC provide access to official filings.

  • Social media and forums can offer real-time insights but should be verified for accuracy.

  • Newsletters, podcasts, and webinars offer expert opinions.

  • Watchlists on financial platforms facilitate personalized tracking.

  • Lastly, participating in earnings calls provides direct access to a company's management.


Regularly utilizing these resources will help you make informed decisions.


3. Set Realistic Expectations


Understand that investing in non-profitable stocks is speculative, and not all companies will become profitable. Be prepared for the possibility of losses.


One example of a non-profitable company that eventually filed for bankruptcy is "Toys "R" Us."


Toys "R" Us was once a dominant player in the toy retail industry, with a vast network of stores across the United States and internationally. However, in the early 2000s, the company began facing financial challenges. It had taken on a significant amount of debt as part of a leveraged buyout in 2005, which burdened its finances.


Several factors contributed to Toys "R" Us' decline, including increased competition from online retailers like Amazon and changing consumer preferences. The company struggled to adapt to the evolving retail landscape, and its debt load made it difficult to invest in e-commerce and store improvements.


In September 2017, Toys "R" Us filed for Chapter 11 bankruptcy protection, attempting to restructure its debt and revitalize its business. Unfortunately, these efforts were not successful, and the company eventually announced the closure of all its U.S. stores in March 2018. The company's bankruptcy and liquidation marked the end of an era for one of the most well-known toy retailers in the world.


This example highlights the importance of adaptability and financial sustainability for both for-profit and non-profitable organizations. A failure to address financial challenges and adapt to changing market dynamics can lead to bankruptcy and the ultimate closure of a company, regardless of its initial success or prominence.


So, from the experience of Toys "R" Us, we can get some inspiration on what to watch out for in the case of NIO (or any other company).

  • Debt Burden: a basic indicator is the debt-to-equity ratio. In the case of NIO, it is about 1.54, which means it has more debt than equity. The total debt is also consistently rising over time. Not good.

NIO Debt
NIO Total Debt. Source: Financial section on SeekingAlpha.com
  • Competition

As we have seen in previously presented statistics, the competition is tough.

  • Changing Consumer Preferences

Although the EV technology is controversial, the trend towards EV adoption is very accelerated.

  • Failure to Innovate

I don't think it is the case for NIO.

  • High Operating Costs

Not a good picture, again. The Selling and Admin expenses jumped in 2021 and then once again in 2022. the R&D expenses rose as well, but this is less concerning as the company has to innovate. Both increases are well reflected in the total operating expenses.

NIO Expenses
NIO Expences. Source: Financial section on SeekingAlpha.com

Ultimately, the combination of excessive debt, stiff competition, changing consumer preferences, and an inability to innovate and adapt can lead to a company's downfall. Despite historical success and iconic status, these challenges can prove insurmountable, and the company might be unable to recover, resulting in its ultimate closure and liquidation.


4. Long-Term Perspective


Consider a long-term investment horizon. Non-profitable companies may take several years to achieve profitability. Be patient.


However, in the case of NIO, the forecast of break-even is not clear at all.

NIO EPS estimate
NIO EPS Estimate. Source: TradingView

5. Seek Professional Advice


If you're unsure about your ability to assess non-profitable stocks, consider consulting with a financial advisor who specializes in growth investing.


No additional comments here. If you are reading this article, you are on the right track.


Conclusion


Valuing non-profitable stocks requires a different approach compared to established, profitable companies. By evaluating the business model, growth potential, and using specialized valuation methods, you can make more informed investment decisions in this exciting but risky space.


Remember to conduct thorough due diligence, manage risks, and maintain a long-term perspective when considering investments in non-profitable stocks. While the journey may be uncertain, the potential rewards can be substantial for those who choose wisely and patiently.


As per NIO stock in particular, I would rate it as HOLD, although I sold my holdings after my analysis.


I hope this was useful for you.


Feel free to use this article as an analysis checklist whenever you intend to invest in a not yet profitable stock.


Happy Investing,


Alex

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