I feel I am in good company in not fully understanding technology companies. During the 1999-2000 tech boom, Warren Buffett copped a lot of flak as arguably the world's most famous tech-averse investor.
At the time, investors who were making money hand over fist by buying ever-popular technology stocks criticised Buffett for saying he didn't understand technology. Buffett was not suggesting he was dumb or incapable of doing the maths, rather he didn't understand the fervour nor the prices being paid for unproven and unprofitable technology companies.
Read more: Xero shares savaged after $69.5m loss
He tried to explain it simply: "In the whole United States there are probably around 400 companies earning $200 million a year after taxes. Five years from now, instead of 400 being on that list, there'll probably be 450, maybe 475. If you look at the number of companies selling today at a price which implies $200 million or more of earnings, you'll find dozens and dozens of such companies in the high-tech arena.
"A very large percentage of those companies aren't going to fulfil people's expectations. And I can't tell you which ones they'll be."
Buffett had the last laugh when the dotcom bubble burst in 2001 and he is still a happy investor today, despite missing out on numerous money-making opportunities that arose in the tech sector in the past decade. His investing philosophy precludes him from investing in companies that don't make profits - "value is destroyed, not created, by any business that loses money over its lifetime" - and don't have a sustainable competitive advantage.
Bearing Buffett's philosophy in mind, I was intrigued to read comments from Xero chief executive Rod Drury last week around how investors should view and value Xero shares. After announcing a $69.5 million loss and seeing the Xero share price fall 9 per cent, Drury suggested that "loss is less fundamental to the assessment of performance, as significant investment is required upfront to attain customers and drive future revenues."
I am sure Buffett would share my view that profit or loss is entirely fundamental to the assessment of performance. Without earnings, we are left to assess metrics such as revenue, client acquisition and market share as a measure of the company's success. To put a value on such a company, we need to guess how these clients, revenue and market share might grow over time then discount these estimates back to today's dollars - and keep fingers crossed that this growth will indeed eventuate.
Drury is not alone in suggesting that so-called "growth companies" should be valued differently.
Traditional accounting is based on a double entry system matching income and costs - with the difference being profit or loss. When $1 of sales is received, it is popped on one side of the income statement and the cost of getting that $1 (sales and marketing, R&D and general expenses etc) is popped on the other side.
The problem with companies like Xero, which operate on a subscription basis, is that as a customer signs up for an ongoing contract, the company receives its revenue each month or quarter or year, but has already incurred all of its costs to win that client upfront. The company has already paid for sales and marketing, developing and maintaining the software and infrastructure, and sets about selling it to as many customers as possible. The timing of income and costs are not matched.
Businesses like Xero are forward-looking rather than backward-looking. The success of the business is about what it is likely to make this year, next year and the next, not what it has earned and spent in the previous period. The problem is, forward-looking businesses require estimates, projections, assumptions and yes, finger crossing. Backward-looking businesses, like those that count earnings rather than revenue as a measure of success, still require some assumptions as to whether their success will continue.
At least with a profitable company it isn't a complete leap of faith as to whether recurring revenue will continue to recur.
This column is presented in association with Fisher Funds