How does a company continually make no profits and proceed to stay in business? It seems counterintuitive at best. However, companies can become successful even without turning profits for extended periods of time – and can even simultaneously continue to attract investors.
There are three basic ways big companies survive without profits.
Purposeful Reinvestment – Earnings are significant and large, but the company chooses to put most of its revenues back into the business to keep propelling growth. Amazon is the king of purposeful reinvestment, infrequently reporting a profit in its more than twenty years of existence and following an overt strategy focused on continued growth over profits.
Amazon has the revenue and base to allow profits, but it argues that without constant investment in its business, the company would be overtaken by competitors in different fields.
Hopeful Expansion – Twitter is a good example of this category. With recent acquisitions such as Vine, Periscope and MoPub, Twitter is trying to carve out a larger social media presence but is dealing with considerable expenses, including almost 45 percent of revenue paid out in compensation as stock options. As opposed to Amazon, the intent is to reach and sustain profitability; however, according to an article in The Motley Fool, the anticipated seventy-percent growth rate still requires a double-digit percentage drop in operating expenses to reach profitability.
The consumer review site Yelp was in this position but finally achieved profitability in 2014. The privately held music-streaming service Spotify is in a similar but more precarious position. Spotify continues to post increasing revenues and continuous losses, up to $1.3 billion and $197 million respectively in 2014. The profit strategy is to hook increasing numbers of listeners with the free service and upsell users to their paid service. However, the ad business has not yet taken off and Spotify is fending off multiple new competitors, including a formidable one in Apple Music.
Zillow also falls in this category and, despite high revenue, is struggling due to equally high costs with limited ways to reduce them. The acquisition of rival Trulia may help.
Initial Growth – The company shows incredible growth and promise in its early stages and secures venture capital funding. Investors see the massive growth potential and shrug off the early lack of revenues.
Uber may be the top example in this category. Uber's estimated market valuation is insanely high (between $40 billion and $50 billion by various estimates), exceeding the valuation of established airlines and car-rental companies. This is driven by confidence in Uber and accepting its staggering expectations of growth. However, the sheer size of the backing is going to make it difficult for Uber to deliver long term.
During this stage, it is important to convince investors that profits will follow. Loss of confidence in future profits can quickly spiral.
As an investor, why do you want to continue investing in these companies? That depends on how much you trust the growth models that keep the stock prices high – and whether the companies in question will meet their eventual goals, whatever they may be.
You have to evaluate these firms a little differently. For example, price-to-earnings ratios have no meaning if there are no profits. A price-to-sales ratio may make more sense.
It is also important to review the business plan in detail. What is the stated path to make money and what are the company's assumptions in getting there? Do they seem realistic in light of the overall market and potential competitors?
A company can survive without profits and you can make money off that company – but first, make sure you understand the underlying reasons for the lack of profits and the amount of risk you are taking with your investment. Investing in Uber and Amazon at this point clearly has different risk/reward values.