A loss-making business - Purplebricks

As an example of a loss-making business I am going to use online estate agency Purplebricks (AIM:PURP).

Just to make things clear right from the start, I am not intending to do a detailed analysis on this company or pass a judgement as to whether its shares are cheap or expensive. I have chosen this company because it is a relatively simple business for readers to understand which lends itself nicely to some of the analysis tips I will show you.

To do a thorough analysis of this business can take days and weeks - something I haven't got time to do at the moment. This means some of the number crunching will be very rough and ready rather than trying to be accurate.

What I am trying to do here is show you how to get a feel for the important issues which can help you make a more informed decision about a company and its shares. These are equally applicable to profitable companies as well as loss-making ones.

Step 2: Build a quick snapshot of the company's recent financial performance

Before you start digging into a company's accounts build yourself a very quick snapshot of a company's key financial performance. This will quickly tell you a great deal about a company's recent past and help focus your research efforts so that you concentrate on what's important.

Here's a quick financial snapshot of Purplebricks.

We can quickly see that this is a relatively young business with only five years' reported results. Sales have grown rapidly and losses have been coming down. The company's financial position looks strong - it has a rising cash balance, no borrowings and increasing amounts of shareholders' equity. Investment in assets (capex) has been rising but is not a large chunk of sales - perhaps indicating that this is not a business that requires a lot of additional investment in assets to grow.

Note that the number of shares in issue has increased. This is a sign of raising fresh money from shareholders - as the cash balance has increased as well - and/or new shares being issued to employees. This is an important development to keep an eye on with growing companies as existing shareholders can be at risk of seeing their ownership stake being diluted by large new share issues.

Step 4: The type and costs of growth

The type of growth of a company is a very important consideration for investors. Growth is much easier to achieve in a market which is also growing. It is more difficult to grow by taking business from existing companies in a market - because the incumbent operators can fight back.

Purplebricks is going to try and grow by taking market share - the number of selling or letting instructions - in the UK estate agency which is the more difficult route. The UK housing market is sluggish at the moment and is unlikely to result in more people selling their homes according to most property experts.

The company also wants try and take market share in Australia and the USA. The key to the valuation of the company will be ultimately determined by how big a slice of the market it can take.

As well as the type of growth the other crucial consideration is how much it will cost to grow. The cheaper it is to grow, the more profitable and successful a company - and possibly an investment in its shares - is likely to be.

The first point to acknowledge is that losses in themselves are a cost of growth. The longer it takes to make a profit, the less valuable a business tends to be. You then need to see whether costs are revenue costs (expensed against revenues e.g. staff costs and advertising) or capital costs such as new IT systems. You then need to try and understand whether the costs are variable - move in relation to revenue - or are largely fixed.

You can get some help with answering these questions by looking at the company's recent financial performance and doing a few simple calculations.

Let's take a look at the income statement of Purplebricks' UK business.

UK Business (£m)	2015	2016	2017
Revenue	3.4	18.6	43.2
Gross profit	2	10.6	24.2
Admin costs	-3.9	-9.6	-9.6
Sales & marketing	-3.5	-12.9	-14.4
Operating profit	-5.4	-11.9	0.2
Gross margin	58.8%	57%	56%
Operating margin	-158.80%	-64%	0.50%
Admin % of sales	114.70%	51.60%	22.20%
Marketing % of sales	102.90%	69.40%	33.30%

We can learn quite a lot from just a few numbers here.

The first thing to note is that the gross profit margin (gross profits as a percentage of revenue) has been relatively stable. This is telling us that the cost of sales - a large chunk of which will probably be the commissions paid to LPEs for getting sales instructions - is not changing that much and is rising in line with revenues.

Let's look at revenue costs first.

Admin costs such as the central costs of running the business have not changed between 2016 and 2017 and fallen significantly as a percentage of sales. Marketing costs are also growing at a much slower rate than sales.

These two costs have a significant fixed element and are likely to grow at a much slower rate than revenues as the company grows. This allows a greater chunk of the growing revenues to feed through to extra profits. More on this shortly.

The company also has reasonably significant share-based payment expenses. I've seen some analyst reports on Purplebricks that add this expense back (on the basis of it being non-cash) but I'm not a fan of doing this. Other shareholders lose out because of them and so I think treating them as an expense is the right thing to do. This cost is likely to be a feature in the future as more LPEs receive shares as part of their pay.

Now let's turn our attention to capital costs.

The main cost here is the investment in IT infrastructure and the development of the company website. This should not be a big underlying cost going forward - mainly replacement of old systems when needed - as the IT platform can cope with growing numbers of customers. The increases will come from setting up systems and websites in Australia and the USA.

Given the lack of high street offices this is a business that should be very asset light when it matures. This means that capex should not be too big an issue and that there should not be too big a difference between profits and free cash flow for shareholders.

Step 6: Estimating the value of the business in a mature state

One way of estimating the value of any business is to work out what it would be worth as a steady state (say growing only by the rate of inflation annually) and then put that value in today's money with a present value calculation.

There is a very neat and simple formula for valuing a steady state business based on its post tax profits or free cash flow.

Value = (Profits or FCF) / (Required return less growth rate).

If you want to you can avoid all this and keep this simple by putting a multiple on the profits instead. Just make sure it is reasonable and reflects a mature rather than rapidly growing business.

Using a 2% growth rate and 8% required return on the profit estimates gives me a value for Purplebricks UK and Australian businesses combined of £1,254.5m. I then get that back to a value in September 2017 by discounting this value by 1.08 to the power of 4.5 years). This gives a value in today's money of £887.3m. The £71.3m of cash is added to this to give a present value of the business of £958.6m or 328.1p per share with no value given to US opportunity.

Purplebricks (£m)	Profit	Tax	After tax profit
UK	59.9	-10.2	49.7
Australia	35	-9.45	25.6
Total	94.9	-19.6	75.3
Business Value			1,254.50
Value today			887.3
Cash balance			71.3
Enterprise value			958.6
Shares			271.8
Options			20.3
Fully diluted shares			292.2
Value per share (p)			328.1

This valuation also ignores the £100m or so of profits that could be made between 2018 and 2022 or another 34p per diluted share which would take the valuation up to just under 363p per share excluding any value for the US business.

As I said earlier, this is a rough and ready exercise and is not meant to be an opinion on the investment merits or otherwise of Purplebricks shares. But it does give some insight as to what the business - excluding the US - would be worth based on a given set of assumptions.

Your job as a private investor is to work out what assumptions are reasonable but I have given you some kind of steer as to how to calculate the value of them. This is moderately advanced analysis but it is great for getting you to think about different scenarios and what they might mean for a company's valuation.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.