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One of the ways that analysts try to normalize earnings for a money losing companies is to take the average earnings of the companies for the past 5 years and replace the current earnings with that number.
What are the implicit assumptions of this?
- Your first assumption is that your last year losses are unusual and they will revert back to normalcy as in the last 5 years -
- Your second assumption is that the the problems that caused the unusual losses this year have disappeared and been resolved.
- Your third assumption is that the business hasn’t changed in any fundamental ways - if there is disruption and/or the company is getting worse, averaging over the last 5 years can’t possibly help you.
- Your 4th assumption is that the company has not scaled up or down over the last 5 years. When you take the average dollar earnings over the last 5 years - even if it’s normal, you are missing the fact that your company might have changed in size over the last 5 years.
- There are ways to go around this, you can use average margins over the last 5 years applied to revenues.
You can do this for very very few companies - maybe old time cyclic companies where there is been recession. For most, it won’t work.
You are implicitly assuming that:
- Markets have to stay open and accessible - no idea what this means…
- Alright, so what he means to say is that, even through FCFE is negative, the company is still able to raise capital - like Amazon, during the .com bubble where it was losing money big time but was still able to raise capital, especially during the .net bubble. However, the very next year, when A.D. had to value Amazon, he had to be ore cautious - the bubble had burst and the market shut down for the most part. Venture Capital, Risk Capital pulled back on investing.
The inherent idea behind this question is that, when high growth companies, or any company for that matter is showing future FCFE as losses, how will it raise money to justify these cash flows? When you value companies, you have to answer this question and therefore, when you still go ahead and apply negative FCFE, you are inherently assuming that the markets are open and accessible enough for your target company to raise capital required for this negative cash flows.