Shareholders of materials group Versarien (LSE: VRS) have seen the value of their stock rise by 296% over the last year. However, those same shares have also lost 37% of their value since peaking in January.
Now seems like a good opportunity to take stock of the situation and I believe potential investors need to answer two questions:
What's the outlook for the business?
Are the shares attractively valued?
A new opportunity
The firm's big hope for future growth lies in products which use graphene, a carbon material that could be the next wonder material.
Most potential uses for graphene are still in the development stage. A good example is the medical trial announced by Versarien today. This will see the firm work with a surgeon at Addenbrooke's Hospital in Cambridge to test a new type of wound dressing.
The firm will develop "a range of graphene-based sensor technologies to enable the creation of digital bandages and wound dressings capable of various forms of physiological movement and excretion detection."
From what I can tell, the goal of this is to produce dressings which enable a patient recovering at home to tell when their dressing needs changing, or if their wound is becoming infected.
The firm is also working on potential products for the chemical, aerospace and consumer goods sectors plus a potential joint venture manufacturing facility in China.
Of course, Versarien isn't the only materials firm hoping to make money from graphene. It faces tough competition from rivals. Not all of this information is public -- many larger companies wouldn't bother announcing early-stage trials like these.
What are the shares worth?
The commercial potential for graphene could be massive and Versarien could do well. But shareholders need to consider the financial picture as well.
It could be several years before the company achieves commercial success from graphene. In the meantime, it will need cash to support its operations. Some of this will come from existing operations.
The group's revenue rose by 167% to £4.37m during the first half of this year. Broker forecasts suggest that full-year revenue will rise by 28% to £7.6m for 2017/18 and by 47% to £11.2m in 2018/19.
Unfortunately, this progress won't generate much profit. Brokers expect a loss of 0.3p per share this year and earnings of 0.6p per share next year. So profits will probably still be a long way short of what's needed to justify the current share price of 76p.
Although the firm raised £2.8m of fresh cash by selling new shares in November, the interim results show a cash outflow of £1.1m during the period. This suggests to me that the company could run out of cash again in a year or so, given the planned investment in production facilities.
Why I'd sell
The firm's current market cap of £113m is more than 10 times next year's forecast sales. That's a very steep valuation for a company that's still running at a loss.
By comparison, Morgan Advanced Materials, a profitable rival, trades at less than one times sales.
I believe Versarien's sky-high valuation leaves shareholders exposed to a lot of downside risk. Even if Versarien is successful, the shares could fall a long way from current levels before they find support.
Turning £10k into £1m
Versarien's multi-bagging performance has made money for a lot of investors. But you'll need more than one big winner if you want to build a £1m stock portfolio.
That's why our expert analysts have produced Your 10-Step Guide To Making A Million In The Markets. This exclusive report contains a simple 10-step investing strategythat could help you make big bucks by spotting future winners.
This report is free and carries no obligation. To download your copy today, click here now.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Morgan Advanced Materials. 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.