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One sign of a bubble: traditional valuation principles are abandoned because "this time it's different". See Nifty Fifty, 2000 dotcom, 1920's crash, 2015 Chines

One sign of a bubble: traditional valuation principles are abandoned because "this time it's different". See Nifty Fifty, 2000 dotcom, 1920's crash, 2015 Chinese A shares, ... . It usually requires a new generation of people to enter the market because most people learn only on their own mistakes, not on other people mistakes. This article talks about what negative cash flow means for the company. But what does it mean for the investor? A company that cannot go cash flow positive is worth zero - the value of the company is max(all future cash flows discounted by the interest rate curve, 0). The max(, 0) comes from the concept of the limited liability company.

ummonk 7y ago
Edit: misread max as min, nvm.
- deleted 7y ago
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- pjc50 7y ago
  Forever?
gizmo686 7y ago
Doesn't said company still have assets? At some point, the company can just dissolve and liquidate its assets. Assuming the assets are worth more then the companies debt, this leaves something to distribute to shareholders.
- deleted 7y ago
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- deleted 7y ago
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- Someone 7y ago
  If the company hasn’t been cash flow positive over its lifetime, it is unlikely that the assets will be worth more than the debts. Investments in machinery almost invariably depreciate significantly the moment they are bought, and salaries paid to personnel, electricity to power the lights in your office building, money spent on legal, etc, all lead to zero assets. It can happen if most of the assets are products the company made, and the company can produce them below market value, but then, why would it have have products in store, and not sell them? There are exceptions, but they’re easily recognized. On the one hand there’s seasonal demand: companies growing Christmas trees, or producing umbrellas, hockey skates, etc. On the other hand, there’s companies with long production times such as whiskey distillers or factories building nuclear plants.
  - pmart123 7y ago
    Well, this is why it makes a lot more sense for startups to raise equity versus debt typically. There could be some exceptions such as using the debt to buy required hard assets, but typically, it makes very little sense.
- AmericanChopper 7y ago
  Not all negative cash flows are created equal. For most high valued companies that are cashflow negative, the deficit should represent a portion of their sales and marketing budget. In that case they are literally choosing to be cashflow negative as an investment in growth, and could choose to become cashflow positive at any point by reducing the sales and marketing budget. Obviously this depends on things like their CAC and LTV being healthy, but investors aren’t stupid, and in isolation being cashflow negative isn’t an indication about the sustainability of the company.
  - mason55 7y ago
    Your case (LTV > COGS + CAC) is accounted for in a standard DCF model. If you're planning to be cash flow negative for 30 years because of R&D costs then that's fine but you better have a model where 30 years from now you're able to beat 30 years of interest (and by quite a bit given the risk profile). Grandparent was talking about the case where CF never goes positive. In that case the company in theory still has some shareholder equity by way of assets. But in reality, especially for something like a software company, there aren't going to be a lot of assets to strip out when you unwind the company.
    - AmericanChopper 7y ago
      The existing customer base is an asset. If you can profit from taking a negative CF company, firing all the staff and collecting subscription fees from the existing customers until they all churn, then you have value that can be extracted from the company. These ”maintenance mode” acquisitions aren’t even that uncommon. But that said, it’s not exactly obvious which funded companies will never be profitable. If it was then you’d expect it would be quite hard for them to secure funding. This is simply a conclusion that many HN commenters love to jump to when deriding a particular company, usually without a very good understanding of the company’s financials, or even of finance in general.
    - deleted 7y ago
      [deleted]
- mason55 7y ago
  I think that your argument is with the part about a company being worth $0 if it's not cashflow positive? In theory that's the case but obviously it depends on a lot of factors, and if we're talking about software startups then they typically would have very little in terms of assets to unwind. Maybe some office furniture or a bit of IP. But most of the cash is going to stuff like employee salaries, leasing office space, and cloud computing infrastructure, so by the time you decide to shut it down there's going to be very little left in terms of shareholder value.
- eru 7y ago
  You'd need to get the managers to dissolve the company. Remember when Yahoo was worth 'negative dollars'?
JJMcJ 7y ago
> a new generation of people For example, the generation that remembered the Great Depression and its aftermath did not fully pass from power till around 1990, for instance the elder President Bush. After that the risks did not seem so great.
- didericis 7y ago
  I think this is a lot of why the 50s and 60s is remembered so fondly by many people in the United States. Of course there were lots of major problems at that time and a lot of that fondness is just nostalgia, but I think there are legitimate reasons to think that way. The amount of turmoil and first hand mistakes that generation had to live through early on in their lives was pretty staggering, and I think the high stakes consequences and first hand experience of what it means to make unnecessary risks, while also experiencing the unavoidability of risk, lead a disproportionate number of people in that generation turning out as good/effective leaders and team members. Basically I think that whole hard times create strong men, strong men create good times, good times create weak men, weak men create bad times thing is probably true, and it probably applies as much to economic bubbles as it does to politics/times in general.
  - ethbro 7y ago
    Wouldn't that logic mean the recession will ultimately lead to Gen Y being good/effective leaders? Personally, I'd counter it was the inequality compression caused by WWII that lead to the prosperity of the 50s and 60s. Or in other words, on the timescale of decades, the mob of capital doesn't act in its own best interests. Because individual greed overcomes sustainability.
    - simula67 7y ago
      > Personally, I'd counter it was the inequality compression caused by WWII that lead to the prosperity of the 50s and 60s. I think it was the entire productive capacity of the remaining world being bombed to destruction was the reason the USA experienced prosperity during that period. The US dollar becoming the international reserve currency probably helped also.
streetcat1 7y ago
We are living in a new financial regime of negative interest rates. What happened before 2008/2007 does not apply now.
rgoldste 7y ago
I catch your drift, but this isn’t technically true. A company with negative discounted cash flows might have a positive expected value because it can undertake a risky project that has a negative expected value. Usually this project will bankrupt the company, but occasionally it will provide a windfall. During bankruptcy, the company might not pay off all of its debts, but it can’t be worth less than 0 due to limited liability. During the unlikely event of success, the company is worth something. If you want to know more, look up “moral hazard” and “real options”.
- iscrewyou 7y ago
  Not OP. But that’s a hypothetical for a company who is already in business and is betting on a product. Right? Like Sony betting on the next gen console by selling it at a $100 loss but then make it up later when they take hold of the market. But that’s Sony and one of their products. I see Moral Hazard as an example of that. Nowadays it’s almost every company betting their whole business hoping that their product will come out on top or they’ll let the public pay for the debt through IPOs.
- roenxi 7y ago
  If I'm reading you correctly you are arguing to something slightly different than what OP said. OP says that if a company can't go cash flow positive it is worthless, you say there there is always a chance that a company might experience a sudden turn around and go cash flow positive. Both are true. However, theory and practice are identical only in theory. If there is a company with negative projected cash flows relying on a negative-expected-value project succeeding unexpectedly that company is probably near worthless. If ordinary investors are relying on "maybe things won't turn out the way we expect them to"-style logic to make their investment decisions then the market is doomed.
  - TeMPOraL 7y ago
    > However, theory and practice are identical only in theory. If there is a company with negative projected cash flows relying on a negative-expected-value project succeeding unexpectedly that company is probably near worthless. Well, Uber is an exception to this rule apparently. The way I read the GP, they're just saying that LLCs are good to be used for gambling.

ummonk 7y ago

Edit: misread max as min, nvm.

deleted 7y ago
[deleted]
pjc50 7y ago
Forever?

gizmo686 7y ago

Doesn't said company still have assets? At some point, the company can just dissolve and liquidate its assets. Assuming the assets are worth more then the companies debt, this leaves something to distribute to shareholders.

deleted 7y ago
[deleted]
deleted 7y ago
[deleted]
Someone 7y ago
If the company hasn’t been cash flow positive over its lifetime, it is unlikely that the assets will be worth more than the debts. Investments in machinery almost invariably depreciate significantly the moment they are bought, and salaries paid to personnel, electricity to power the lights in your office building, money spent on legal, etc, all lead to zero assets. It can happen if most of the assets are products the company made, and the company can produce them below market value, but then, why would it have have products in store, and not sell them? There are exceptions, but they’re easily recognized. On the one hand there’s seasonal demand: companies growing Christmas trees, or producing umbrellas, hockey skates, etc. On the other hand, there’s companies with long production times such as whiskey distillers or factories building nuclear plants.
- pmart123 7y ago
  Well, this is why it makes a lot more sense for startups to raise equity versus debt typically. There could be some exceptions such as using the debt to buy required hard assets, but typically, it makes very little sense.
AmericanChopper 7y ago
Not all negative cash flows are created equal. For most high valued companies that are cashflow negative, the deficit should represent a portion of their sales and marketing budget. In that case they are literally choosing to be cashflow negative as an investment in growth, and could choose to become cashflow positive at any point by reducing the sales and marketing budget. Obviously this depends on things like their CAC and LTV being healthy, but investors aren’t stupid, and in isolation being cashflow negative isn’t an indication about the sustainability of the company.
- mason55 7y ago
  Your case (LTV > COGS + CAC) is accounted for in a standard DCF model. If you're planning to be cash flow negative for 30 years because of R&D costs then that's fine but you better have a model where 30 years from now you're able to beat 30 years of interest (and by quite a bit given the risk profile). Grandparent was talking about the case where CF never goes positive. In that case the company in theory still has some shareholder equity by way of assets. But in reality, especially for something like a software company, there aren't going to be a lot of assets to strip out when you unwind the company.
  - AmericanChopper 7y ago
    The existing customer base is an asset. If you can profit from taking a negative CF company, firing all the staff and collecting subscription fees from the existing customers until they all churn, then you have value that can be extracted from the company. These ”maintenance mode” acquisitions aren’t even that uncommon. But that said, it’s not exactly obvious which funded companies will never be profitable. If it was then you’d expect it would be quite hard for them to secure funding. This is simply a conclusion that many HN commenters love to jump to when deriding a particular company, usually without a very good understanding of the company’s financials, or even of finance in general.
  - deleted 7y ago
    [deleted]
mason55 7y ago
I think that your argument is with the part about a company being worth $0 if it's not cashflow positive? In theory that's the case but obviously it depends on a lot of factors, and if we're talking about software startups then they typically would have very little in terms of assets to unwind. Maybe some office furniture or a bit of IP. But most of the cash is going to stuff like employee salaries, leasing office space, and cloud computing infrastructure, so by the time you decide to shut it down there's going to be very little left in terms of shareholder value.
eru 7y ago
You'd need to get the managers to dissolve the company. Remember when Yahoo was worth 'negative dollars'?

JJMcJ 7y ago

> a new generation of people For example, the generation that remembered the Great Depression and its aftermath did not fully pass from power till around 1990, for instance the elder President Bush. After that the risks did not seem so great.

didericis 7y ago
I think this is a lot of why the 50s and 60s is remembered so fondly by many people in the United States. Of course there were lots of major problems at that time and a lot of that fondness is just nostalgia, but I think there are legitimate reasons to think that way. The amount of turmoil and first hand mistakes that generation had to live through early on in their lives was pretty staggering, and I think the high stakes consequences and first hand experience of what it means to make unnecessary risks, while also experiencing the unavoidability of risk, lead a disproportionate number of people in that generation turning out as good/effective leaders and team members. Basically I think that whole hard times create strong men, strong men create good times, good times create weak men, weak men create bad times thing is probably true, and it probably applies as much to economic bubbles as it does to politics/times in general.
- ethbro 7y ago
  Wouldn't that logic mean the recession will ultimately lead to Gen Y being good/effective leaders? Personally, I'd counter it was the inequality compression caused by WWII that lead to the prosperity of the 50s and 60s. Or in other words, on the timescale of decades, the mob of capital doesn't act in its own best interests. Because individual greed overcomes sustainability.
  - simula67 7y ago
    > Personally, I'd counter it was the inequality compression caused by WWII that lead to the prosperity of the 50s and 60s. I think it was the entire productive capacity of the remaining world being bombed to destruction was the reason the USA experienced prosperity during that period. The US dollar becoming the international reserve currency probably helped also.

streetcat1 7y ago

We are living in a new financial regime of negative interest rates. What happened before 2008/2007 does not apply now.

rgoldste 7y ago

I catch your drift, but this isn’t technically true. A company with negative discounted cash flows might have a positive expected value because it can undertake a risky project that has a negative expected value. Usually this project will bankrupt the company, but occasionally it will provide a windfall. During bankruptcy, the company might not pay off all of its debts, but it can’t be worth less than 0 due to limited liability. During the unlikely event of success, the company is worth something. If you want to know more, look up “moral hazard” and “real options”.

iscrewyou 7y ago
Not OP. But that’s a hypothetical for a company who is already in business and is betting on a product. Right? Like Sony betting on the next gen console by selling it at a $100 loss but then make it up later when they take hold of the market. But that’s Sony and one of their products. I see Moral Hazard as an example of that. Nowadays it’s almost every company betting their whole business hoping that their product will come out on top or they’ll let the public pay for the debt through IPOs.
roenxi 7y ago
If I'm reading you correctly you are arguing to something slightly different than what OP said. OP says that if a company can't go cash flow positive it is worthless, you say there there is always a chance that a company might experience a sudden turn around and go cash flow positive. Both are true. However, theory and practice are identical only in theory. If there is a company with negative projected cash flows relying on a negative-expected-value project succeeding unexpectedly that company is probably near worthless. If ordinary investors are relying on "maybe things won't turn out the way we expect them to"-style logic to make their investment decisions then the market is doomed.
- TeMPOraL 7y ago
  > However, theory and practice are identical only in theory. If there is a company with negative projected cash flows relying on a negative-expected-value project succeeding unexpectedly that company is probably near worthless. Well, Uber is an exception to this rule apparently. The way I read the GP, they're just saying that LLCs are good to be used for gambling.