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In a well-functioning capital market, profits should be the sole criterion for firm survival; that is, firms reporting losses should disappear. Of late, however, loss-making firms are highly sought after by investors — often more than some profitable firms. Unicorns, or startups with valuations exceeding a billion dollars, are examples of such loss-making firms. What has changed over time? When and why did losses lose their meaning? The authors’ series of new research papers provide some answers, guiding managers to make the right investments: those that produce delayed but real profits — not just those that produce short-term accounting profits but decimate shareholder wealth in long run.
In 1979, psychologists Daniel Kahneman and Amos Tversky famously posited that losses loom larger than gains in human decision-making. For example, a dollar of loss affects our behavior more than a dollar of profits. Likewise, when a firm announces losses, its stock price declines more dramatically than it increases for the same dollar amount of profits. Investors abandon and lenders tend to stop financing loss-making firms, which then start restructuring their business lines and laying off employees. Some firms go even further, conducting M&A transactions without substance and “managing earnings” to report profits instead of a loss.
