Personal Finance & Money Asked on August 17, 2021
What does the valuation of a company mean, exactly?
What is it based on and how is its “correct” value calculated?
For example, a valuation of $1 million for a company that has had $50k in profits the past year is usually seen as quite ridiculous (or at least it is, as far as I can tell from watching Shark Tank).
Yet if the profits were $500k instead, then the valuation would be more likely to be seen as reasonable.
So how do you tell what the “correct”, optimal valuation for a company is?
What makes a valuation of $1 million “good” for a company with $500k in profits, but bad for a company with $50k in profits?
The textbook answer would be "assets-liabilities+present discounted value of all future profit".
A&L is usually simple (if a company has an extra $1m in cash, it's worth $1m more; if it has an extra $1m in debt, it's worth $1m less).
If a company with ~0 assets and $50k in profit has a $1m valuation, then that implies that whoever makes that valuation (wants to buy at that price) really believes one of two things - either the future profit will be significantly larger than $50k (say, it's rapidly growing); or the true worth of assets is much more - say, there's some IP/code/patents/people that have low book value but some other company would pay $1m just to get that.
The point is that valuation is subjective since the key numbers in the calculations are not perfectly known by anyone who doesn't have a time machine, you can make estimates but the knowledge to make the estimates varies (some buyers/sellers have extra information), and they can be influenced by those buyers/sellers; e.g. for strategic acquisitions the value of company is significantly changed simply because someone claims they want to acquire it.
And, $1m valuation for a company with $500k in profits isn't appropriate - it would be appropriate only if the profits are expected to drop to zero within a couple years; a stagnant but stable company with $500k profits would be worth at least $5m and potentially much more.
Correct answer by Peteris on August 17, 2021
There is no such thing as a correct value.
There are different ways to calculate (read: guess) an anticipated value, but neither of them is the "correct" one. Last not least this depends on your interpretation of the term "correct" in that context.
Why do you think paid Facebook such a huge amount for WhatsApp? Surely not, because it was the "correct" value.
Answered by JensG on August 17, 2021
It's safe to say that for mature companies, with profits that have been steady, and steadily growing, that a multiple of earnings can come into play. It's not identical between companies or even industries, but for consumer staples, for instance, you'll see a clustering around a certain P/E.
On the other hand, there are companies like FaceBook, 18 months ago, trading at 20, now at 70 with a 110 P/E. Did the guys valuing the stock simply get it wrong then or is it wrong now?
Contrast this with KO (Coca-cola) a 20 P/E and 3.2% dividend, PG (Proctor and Gamble) 21 P/E, 3% dividend.
Funny though, a $1M valuation for $50K in profit may be Shark ridiculous, but a $1B valuation on a $50M company with great prospects, i.e. a pipeline of new products in growing markets, is a steal.
Disclosure I have no positions in the mentioned stocks.
Answered by JTP - Apologise to Monica on August 17, 2021
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