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Understanding Business Valuations

If you’re going to participate in the world of business, it’s important to know the rules. One of those rules is how businesses value themselves, and are valued by other—whether they’re public or private.

First, we need to dig back into how stock markets work, because they drive how even private companies are valued.

In the beginning, people invested in stock markets in order to get a dividend. That is, your investment was a kind of loan, and the dividend—a portion of the company’s quarterly or annual profits—was the interest on that loan. In theory, a company never had to grow: they just had to keep doing the same thing, paying the same dividend, and you might be happy.

Ah, but nobody’s ever happy. Investors wanted more dividend, which required the company to do more business—to grow, in other words.

At some point, people started realizing that instead of asking for a dividend, they could chart the company’s growth, and sell their shares of the company’s stock based on the company’s expected growth. The conversation goes something like, “hey, we’ve seen Company X grow about 12% annually. They’re trading at $5 a share now, but in five years that should be 60% more! Buying now locks you into those future gains!”

That’s when a lot of people suddenly started caring about “what a company will be worth in the future.”

Today, analysts and investors have agreed on a broad set of “quick-take” rules to help them guide their advice and decisions. Take any industry, and most can quickly tell you the multiplier range for that industry, which is based on extensive analysis of many different companies in that industry. They might, for example, tell you that SaaS companies have a 6x-8x multiplier, or that fast food is a 2x-3x. I’m making up those numbers, by the way, along with every other number in this article, purely for illustrative purposes.

The multiplier is applied to the company’s current annual revenue, and serves as a guide for what analysts think the company could be making in a few years, if they play all their cards right and execute well on their business model. So a company making $100MM (million) in annual revenue, with a 5x multiplier, would be “worth” $500MM. If they’d issued a million shares of stock, you’d expect those to trade for $500 each. If they traded at $100 each, they’d be undervalued.,and a savvy investor might snap up a lot of stock in hopes of achieving that $500 “target price” in due time.

Different industries also have different standard expectations for growth—because remember, growth is the name of the game. Fast food might be considered “flat,” with little growth opportunity, if the market already looked saturated. A SaaS company might be expected to produce double-digit growth, perhaps 20%, per year on their journey toward their target price.

Valuation can also drive mergers and acquisitions. Suppose you have Company A, making $500MM a year in revenue with a 5x multiplier. They buy Company B, making $100MM a year with a 3x multiplier. Analysts might look at that merged company and decide that its synergies deserve a 10x multiplier, making the combined company worth $6B. Yeah, billion, calculated by taking the combined revenue of $600MM and multiplying by ten.

BTW, the “MM” designation comes from the Latin mil, meaning thousand; MM is therefore “a thousand thousand,” or a million. MM in Latin numbering would only be two thousand, but in modern financial use it’s a million.

Working for a business, it’s important to try and understand its current valuation as well as its current revenue—that tells you how “far off” the mark the company is. A company current making only a hundredth of its expected value has a lot of work to do, and might engage in some “big bets” to try and accelerate their growth. A company that’s flattening out toward their target might actually be considered unhealthy: there’s a kind of unspoken expectation that, if you’re truly a growth business, you’re always moving your “target” further and further up.

And not everyone values “growth” companies. Some investors, especially as a piece of their portfolio, also want steadier-state companies that simply return a reliable dividend. Those are often a good way to balance out the riskier investments in growth companies.

So: what does this tell you about your company, where it’s at, and how it might behave in the future? And how can that information affect how you engage with your company on a daily basis?

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