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This hot stock could shoot the lights out. Here’s why I’m avoiding it like the plague

I last wrote about advanced engineering materials company Versarien (LSE: VRS) in March 2018 and pledged to avoid the stock because of the loss-making and jam-tomorrow characteristics of the underlying business.

Back then, the share price was at 84p. You could say I made a duff call because the stock went as high as 185p by September 2018 and now sits at 115p as I write. However, I was worried about the firm’s finances back then, and I still am. On top of that, even if City analysts’ predictions come true for profits down the road, we could be looking at an eye-wateringly high valuation at the current level of the share price.

A great story, naturally

Naturally, the company has a great story. How else would it have attracted such speculation from investors? It operates with the two divisions of Graphene & Plastics, and Hard Wear & Metallic Products. Graphene, in particular, is known for its potential to disrupt a number of established industries, and a series of collaboration agreements appear to have whipped up speculation about the firm’s future into a froth of exuberance that has driven the share price skywards.

But the financial reality tends to knock off the old rose-tinted spectacles. Today’s full-year results report to 31 March reveals that revenue came in essentially flat compared to the year before at just over £9m. I find that worrying. The firm has spent a whole year investing, trading and presumably selling its story and products, only to stand still with the revenue result.

And it gets worse. The loss before tax increased by 75% to £2.8m. In terms of building a financially viable business, Versarien appears to be going backwards. Meanwhile, we get a sense of the way the stock market is over-valuing the company by comparing the circa £9m revenue figure with the firm’s market capitalisation, which runs close to £179m.

A nose-bleed valuation

Looking forward, City analysts following the firm are optimistic that Versarien can swing from loss to profit. Some have pencilled in earnings of around 1p per share for the current trading year to March 2020. But even if the firm achieves that, the current share price puts the forward-looking earnings multiple at about 115. If you are buying the shares now, you must be expecting a rapid acceleration in earnings in the years ahead.

And Versarien is making all the right noises. Chief executive Neill Ricketts said in today’s report that the year had been one of “great progress… particularly in our emerging technologies businesses, globally and in the UK.” He explained that the firm’s graphene businesses have expanded into global markets “and progress is being seen in our existing collaborations, as well as new collaborations being entered into.”

But I’m sceptical. Before we see a rapid escalation of revenue and earnings, I reckon we are likely to see a rapid contraction of the share price and valuation to adjust to the slow realities of building up new businesses from scratch. I’m avoiding the stock for the time being.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.