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In this article I will examine two companies in order to answer a question that has been bothering me - what is it that enables loss-making companies still make money for investors? How can a company that has been losing money as a business still manage to make money as a stock? How can some stocks manage to live with unrealistic valuations for so long? What makes these stocks tick?

Both salesforce.com inc. (NYSE:CRM) and Workday Inc. (NYSE:WDAY), our objects of study, are in the same sector - technology - and the same industry - software and programming, and both have returned more than 25% in the past one year.

So what's wrong with that, you may ask.

What is wrong is that both are loss-making companies and have been reporting losses quarter after quarter.

Workday Inc.

The company was incorporated in March 2005 and since price data is available only from October 2012 onwards, I assume that it was listed then. The company provides cloud-based applications for human capital management, payroll, financial management, time tracking, and procurement and employee expense management. Its business model focuses on consumer internet and cloud computing experience.

In the quarter ended October 2012, it was able to "surprise" analysts by reporting 12.5% more earnings per share than they were expecting. It is another matter that analysts had forecast a loss of $0.56 per and the company reported $0.49 per share loss. The quarterly earnings report was released on November 28, 2012 and between November 15, 2012 and November 28, 2012 the stock gained 12.26% and has continued moving up and appreciated another 19% since the day results were made public.

Workday released its Q4 and Fiscal Year 2013 results on March 7, 2013. The stock rose almost 17% in the first week of March 2013, only to fall 4.5% on the day results were declared. The results were encouraging as far as total revenue (up 89% from prior quarter) is concerned but the company failed to report a profit. However, at $0.19 net loss per share was considerably lower than per share loss of $0.49 reported in the previous quarter and the loss of $0.77 per share in the same quarter prior year.

Salesforce.com Inc.

Salesforce.com provides cloud computing and social enterprise solutions. It provides a customer and collaboration and relationship management applications over the internet or cloud.

The company reported incremental losses in the four quarters before the most recent quarter ended January 2013, results for which were reported on February 28, 2013..

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In the most recent quarter, salesforce.com reported a net loss of $20.84 million. Whereas this is much less than the prior quarter ($220.29 million), the FY 2013 annual loss ($2.70 billion) is far, far more than the $11.57 million loss reported for FY 2012. The fiscal year 2012 and 2013 losses need to be seen in light of the fact that:

  1. quarter-over-quarter as well as year-over-year revenues have been growing - revenue in FY 2013 registered a growth of more than 30% over prior year
  2. the company reported net profit in FY 2010 and 2011

While I do not wish to go into the reasons for such disproportionate figures, I would like to draw attention to this article, should you want to know about CRM figures.

Despite such bleak figures, CRM stock appreciated 9% in March 2013 and 28.29% in one year and 225% in five years.

Bottom Line

In case of Workday, there is some sort of a reasoning that the market reacted to news of a substantial reduction in loss but how does one explain the performance of CRM's stock in light of the fact that it has been making a net loss consecutively for five (actually seven) quarters? Moreover, how does one explain the performance of these stocks in light of their negative margins, operating as well as profit?

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That leaves us to see future prospects. Analysts are not hopeful of Workday's ability to post profits and do not expect it to report a positive EPS in the near future, not even until January 2016. However, they are quite sanguine about salesforce.com and expect it to report an EPS of $0.22 in FY 2014 and $0.7 in FY 2015. However, at current market price, the stock is trading at an exceptionally high forward (January 31, 2015) P/E of 73.20.

We see unbelievably high P/E ratios in the software and programming sector. For example, Interactive Intelligence Group (NASDAQ:ININ), a small-cap company that provides software applications, is trading at P/E of 1,096.87 with an EPS of $0.04. ClickSoftware Technologies (NASDAQ:CKSW), another small-cap company that provides software products and solutions, is trading at a P/E ratio of 38.33. This is explainable because it is a dividend-paying company with a high-dividend yield of 3.65% and $0.23 EPS, which analysts expect will grow by 100% in December 2014.

Such high valuations are not justified. There is also a limit to which one would pay for a stock on the basis of forward earnings. Considering everything, I do not see any logic in the high valuation of Workday and salesforce.com. I would go by what the writer of this article says about the dot.com bubble, "During the late '90s the market was valuing stocks to the moon and analysts had no explanation for it, so they invented explanations".

Source: What Makes These Stocks Tick?