ShmoopTube

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Principles of finance ah la shmoop what's that company worth

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Well sometimes the world values companies based on what they

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call wall street metrics things like price to earnings ratios

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and comparable stock prices or values of competitors maybe even

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multiples of revenue But that's just one set of ways

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to view or value a company and since there are

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so many different types of company's having a few perspectives

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on valuing them is probably a good idea So from

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an investor's perspective the company can be evaluated through green

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lenses You've already seen it a few times in the

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course When you put a dollar in today as an

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investor well you have to get more than a dollar

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back tomorrow or it was likely a bad deal and

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hint from warren buffett Don't do the bad deals only

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do the good ones but when you go shopping for

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stocks or companies or projects to invest in there's a

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discipline that most financial managers follow so that when the

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ceo or bored or angry shareholders yell at them they

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have a foundation to their actions And it's usually something

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a little more sophisticated than because my friend told me

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To the easiest and probably least useful evaluation metric is

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book value Recall that this metric is just the net

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balance sheet value you are holding for a given thing

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with your nerdiest bean counter hat on like you know

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you bought a tractor smelting factory ten years ago for

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one hundred million dollars Today you hold it on the

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books for being worth twenty million in value and well

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it works perfectly fine It'll work for another twenty years

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and while it might sell ala carte for twenty million

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dollars on ebay today well it produces tractors really cheaply

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and just fine Thank you very much or said differently

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for only twenty million dollars of net invested capital today

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from a book value perspective while that smelter is able

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to produce five thousand tractors a year yeah really efficient

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production protractor So in this case the book value is

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highly understated and it's way more common for book value

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to be understated than overstated If the company you're looking

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at uses honest non fraudulent gap accounting most accounting laws

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tend to over depreciate things rather than under it Appreciate

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them Banks insurance companies often arrive a very large part

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Of their value from the assets they have in the

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door that they manage they take a fee at fi

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turns into cash By law they're required to hold a

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minimum amount of cash for the nineteen twenty style rainy

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days So book value gets looked at when valuing banks

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But again book value is kind of window dressing in

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just one very small element in valuing things One silly

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ratio you'll hear quoted every now and then is market

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to book ratio and it's really a measure of how

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bad the book value accounting system is in measuring the

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rial market value of something so let's say we have

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an easy to value public company has forty million shares

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outstanding and trades at eighteen bucks a share That gives

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it a market capitalization of seventeen Twenty million The book

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value of all of its asset is one hundred twenty

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million dollars i e net value held on the books

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for that tractor smelting plant the value of remaining leases

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cash debt patents and so on The market tto book

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ratio here is six it's just the market value of

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seven hundred twenty million divided by the book value one

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Hundred twenty million and that gets you six x This

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is a relatively high ratio It either means that the

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tractor company is really old and has appreciated a lot

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of it's today Well functioning assets to being worth almost

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zero or this isn't a tractor company at all and

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instead is a computer software company where book value truly

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has almost no correlation with anything in theory Ah high

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ratio like this anything better than two acts would be

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a reflection that management used its cash well in buying

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things investing in things for the company But since time

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isn't an element in book value calculations while it's really

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hard to tell whether or not they were good like

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if the company's financial managers double the value of the

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company in two years well that's probably really good unless

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it was a crazy hot area like internet search in

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nineteen ninety nine you know in google being born in

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which case well they would have lagged that search market

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by six hundred percent Well conversely if the manager's had

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taken twenty years to double the book value of the

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company to create a market to book of two ex

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well then they compounded it just seventy two over twenty

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or about three point five percent per year Not very

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good return So you got to take all these book

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value numbers with a grain of salt but they're important

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paying attention to all right moving on that was book

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value Now we're looking at the wall street metric of

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p e ratios price to earnings ratio is got it

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well they're probably the most common metric used by normal

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people to value public or large companies while most small

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companies don't have really fern ings or a long history

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of earnings that can derive fair multiple based on revenue

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growth margins and cash flow production with calculation on this

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one's easy company acts has a hundred million chairs and

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we'll learn after taxes appreciation and everything two hundred fifty

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million dollars they earn how much per share Well two

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hundred fifty million five hundred million shares is to fifty

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a share Their stock trades of fifty bucks it's twenty

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times two fifty twenty times earnings Stock markets historically hovered

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around fifteen twenty times earnings roughly depending on prevailing interest

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rates and the overall global economy and a bunch of

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other factors but twenty times is not a crazy high

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multiple it's high but not crazy high so let's think

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about this number in context of real life Your family

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owns a pizza parlor You worked your tails off all

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year long serving pepperoni beer and salad things you're one

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very large restaurant does a million dollars in sales that

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year and after paying for bread electricity booze rent insurance

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labor little league marketing sponsorships and whatever else you net

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after everything a hundred grand in earnings all right someone

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comes along and wants to buy your pizza parlor what's

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likely you'd be thinking you'd sell it for what three

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hundred grand for hundred grand at that number you just

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sell and move on But if your parlor received a

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quote stock market multiple you'd be getting twenty times earnings

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or twenty times that hundred thousand dollars or two million

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dollars for your pizza parlor Doesn't that sound ridiculously high

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for a building with bread and light like tomato sauce

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in it Some cheese and you don't even own the

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building is part of all this you just rented so

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yeah that's crazy high but what if someone owned five

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Pizza parlors and had a lower body making the pizza

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and kids could custom make their own pizza exactly the

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way they wanted it with x percent cheese and y

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percent spiciness and z percent crusty nous and have it

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all delivered to their home by a drone And they

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could watch it all under glass and a webcam viewing

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in robot making that pizza's entertainment so that they'd finally

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shut up for fifteen minutes while the owner you know

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did the beer thing And what if the owner of

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robot pizza had patents for all his pizza Robotic stuff

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in his much smaller five restaurants today produced a million

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dollars revenue one hundred grand earnings but he had plans

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next year to open twenty restaurants in the next year

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one hundred restaurants the next year three hundred restaurants with

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each one producing twenty grand in profits Well if he

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had three hundred restaurants coffin out twenty grand a year

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will that be six million a year in profits And

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now there's no guarantee he grows from five parlors two

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three hundred in just three years But it isn't crazy

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given their how into the robot maker the kids seem

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To be so now someone looks at buying robot pizza

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and the price is way higher than twenty times earnings

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What if they offered ten million dollars What does that

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number mean Well what they're getting at is which year's

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earnings is that ten million a multiple of against this

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year's hundred grand in earnings it's one hundred times earnings

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crazy high but against the three years from now projected

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earnings of six million dollars it's only like one point

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seven times earnings crazy low But that number carries a

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whole lot of risk that funeral kids fall out of

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love with a robot pieces or that one of them

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escapes the glass and enslaves the kitties and makes them

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so tennis shoes all day long for a dollar The

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basic idea here is that there are lots of variables

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lots of risk lots of unknowns When you hear journalist

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quoting that x y z company just sold for an

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insane hundred times earnings multiple it's likely that is more

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of the same story as robot pizza here Probably there

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was a balance of risk and reward in predicting future

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earnings and whoever the buyer was paid one hundred times

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Last year's earnings Well that buyer haddock Clear vision for

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what the earnings would go up tio and they go

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up a lot In the next few years they figured

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they were really paying just a few times Earnings of

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the earnings three years from now not one hundred x

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last year's numbers let's Just say good financial managers don't

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drive their cars just by looking in the rear view

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mirror Unless there's a robot cracks re driving the car

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