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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?

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Don't forget that the companies on Shark Tank are assumed to be in a specific situation that may not be the case for other companies as Amazon.com would be an example of a company without any profits when it had its IPO in the 1990s. –  JB King Mar 16 at 16:17
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It's a complex topic: en.wikipedia.org/wiki/Business_valuation –  Michael Borgwardt Mar 16 at 16:59

3 Answers 3

up vote 2 down vote accepted

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 $500m in profits isn't appropriate - it's appropriate only if the profits are expected to drop to zero within a couple years; a stagnant but stable company with $500m profits would be worth at least $5m and potentially much more.

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The first sentence hit the nail on the head. All the answers were great though! Thanks! –  Mehrdad Mar 17 at 4:57

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.

  • Book value / value of oustanding shares
  • Discounted (future) cash flow
  • Value (which one?) of tangible and intangible assets
  • Anticipated future market share
  • and so on ...

Why do you think paid Facebook such a huge amount for WhatsApp? Surely not, because it was the "correct" value.

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It can also depend on the bias of the analyst ! –  Victor Mar 16 at 12:17
    
This is the (nearly) correct answer: you forgot comparable sales (eg comparison approach) and break-up value. –  ssaltman Mar 17 at 17:33

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.

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