How Can You Tell What a Stock Is Worth When Its Key Stats Are Negative?

By Markets

In this week's Rule Breaker Investing podcast, Motley Fool co-founder David Gardner addresses the thorny question of companies with negative book values and negative earnings -- i.e., losses. What are money-losing companies worth, and can there be any reasons to place them in your portfolio?

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A transcript follows the video.

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This video was recorded on Aug. 31, 2016.

David Gardner:And the last one this week comes from Andrew. He's @Captain_KillJoy. That's a pretty good Twitter handle. Andrew, you asked: "How do you interpret stock valuation with things like negative P/E or negative book value?"

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Great question. In other words, when a company doesn't actually have earnings or positive book value -- I'm not going to define book value here -- basically when you're just not seeing things that give you normally positive ratios, how do we actually invest or think about those things?

So for me, my best fallback for the many early and disruptive emergent companies that sometimes don't have earnings yet is to look at the top line, and that is sales. So if you look at sales -- let's just pretend the company has $100 million in sales and is worth $2 billion today on the market. That is a very expensive ratio. That's about a 20-to-1 price-to-sales ratio.

So the price-to-sales ratio is a good thing that can ground you and help you understand how any company might compare, by this metric, with any other company, because even though many companies may not have earnings ... almost all of them have sales today, so you can compare valuations using that metric.

Now typically, what I'm looking for are companies that are between 3 and 10 times sales. You can find companies who trade below the value of their own sales. These are very distressed situations where companies may have $1 billion in sales but be worth only $500 million. That's a really interesting situation. They're very distressed. I'm not that interested in those.

You can also find companies that are trading at well more than 10 times sales. A company like Twilio today is trading at a very high price-to-sales multiple. I like to find that 3-to-10 sweet spot. In general, companies that trade at higher multiples of sales are more attractive companies in the market's eyes. Right? We're willing to pay 7 to 8 times sales. These are usually finding the premium-priced things like premium-priced jewelry at Tiffany, or premium-priced coffee at Starbucks. You're finding, usually, quality companies. So that's kind of my sweet spot. It helps you in situations where there is no price-to-earnings ratio.

David Gardner owns shares of Starbucks. The Motley Fool owns shares of and recommends Starbucks and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.