Written By: Bhumika Jain
This is a common question, especially in finance job interviews, and it can be tricky to understand at first. Many financial models, including the Discounted Cash Flow (DCF) model, start with earnings or cash flow projections. So, if a company has negative net income, does that mean DCF can’t be used? Not at all!
The Walmart Example
Let’s take Walmart as an example. In its early growth years, Walmart had negative free cash flow for several years. On paper, this might look like the company wasn’t making money or wasn’t a good investment. But that wasn’t the case.
Walmart was reinvesting heavily in its business – building stores, setting up infrastructure, and creating marketing campaigns. These were investments in its future. Even though this spending made its earnings look negative, these actions were driving the company’s long-term growth and creating value for shareholders.
High-Growth Companies and Negative Earnings
The same situation applies to many fast-growing companies today. Negative net income often happens when a company is spending a lot on growth.
For instance, companies may invest heavily in things like:
– Marketing and branding (intangible assets)
– Research and development
– Infrastructure and technology
According to accounting rules, many of these costs are fully recorded as expenses on the income statement right away. This lowers net income in the short term, even though these expenses might lead to benefits in the future.
How to Use DCF with Negative Earnings
You can still use a DCF model even if a company has negative net income. The trick is to adjust for the impact of these growth-focused investments.
- Shift Intangible Investments to the Balance Sheet: Instead of treating all marketing or R&D expenses as one-time costs, you can think of them as long-term investments. In accounting terms, this means “capitalizing” these expenses and recording them on the balance sheet.
- Forecast Future Cash Flows: Focus on the company’s future cash flow potential, not just its current earnings. Look at how its investments today will contribute to revenue and profits in the future.
- Adjust Discount Rates and Growth Assumptions: Use realistic assumptions about the company’s growth rate and risks to create a balanced DCF model.
Why Negative Earnings Don’t Mean the Company Isn’t Valuable
Negative net income doesn’t automatically mean a company is failing or not worth investing in. Sometimes, it’s simply a result of how accounting rules work. Expenses like marketing and R&D might obscure the true value of the company by making its short-term financials look worse than they actually are.
Instead, take a step back and look at the big picture:
– Is the company reinvesting in growth?
– Are its investments likely to create long-term value?
– Does it have a clear path to future profitability?
If the answer to these questions is “yes,” then the company might still be a great investment, even with negative earnings today.
Conclusion
Negative net income isn’t a deal-breaker for using the DCF model. By adjusting how you account for growth-related expenses and focusing on the company’s future potential, you can still use DCF to value high-growth companies accurately.
It’s all about looking beyond the numbers to understand the story they’re telling.