No, pulling into the current valuation all the future profits is not the point of a valuation. If you did that, there would be no return to ever be had for the investors.
Under that premise, Facebook should have been valued at $200 billion at their IPO (or even earlier).
Google should have been worth $300 billion at their IPO in 2004.
Apple should be carrying a $20 trillion market cap using that calculation, pulling all of their future profits into their present valuation.
Investors do not normally reach a valuation for an investment today, based on profits ten years from now, with the expectation that the price paid today is equal to what the profits in ten years will justify. That's a recipe for not yielding any returns for ten years.
The point of a valuation is to invest capital into a company based on speculation of future returns to be yielded based on future profits, not to pay for all of those future profits with your investment today. The value is determined by the near-present estimation of what the business is worth, and with a potential bias elevating the valuation. The investor return comes from all of those future profits not being priced into the current valuation.
Valuation is not the same thing as revenues per year. Or profit per year.
an easy example: if facebook made 15B per year with 5B in profit, they could distribute dividends of the 5B each year to stockholders. In only 3 years, your original investment would be paid back and it would be all profit (to the investor) from that point on.
Would you think that was a good deal? I would! So good that it'd get bid up on the open market way past 15B.
The 'valuation' of a company is basically the present value of all it's estimated future cash flows (edit: by this I mean profit).
So think of Apple like a 'cash machine' - and it spits out profit to the bank account.
Well - the 'valuation' is just how much we think will be in that bank account.
The inherent problem with this is 'seeing the future' - both in terms of predicting future cash flows way out ... that's obviously hard, but the second part ... is the fact that the value of 'future cash flows' to you might be different than it is to someone else!
Basically, the way we calculate the 'present value' of those future cash flows is by discounting those values by some amount - $100 in 100 years is worth less than $100 tomorrow.
But what 'discount rate' do you use? That's another hard question. Typically, it's the 'risk free rate' i.e. the rate of return you can get on your money by parking it somewhere and doing nothing.
Another term for that is 'cost of capital'. Everyone's 'cost of capital' is different.
So when everyone takes there estimates of 'future Apple cash flows' and then applies their specific 'discount rate' - we then have a balance of supply and demand for their shares and voila - a 'market cap'.
Also we should point out that this is private wealth - and that massive surpluses in one part of the value chain isn't necessarily healthy for you, for me, for anyone else, or 'the economy'.
For example - what if Apple had more competition? Well, then we might be getting the very same great Apple products for 20% less. Apple might be making 'very little profit' but nevertheless be providing you and I with vast consumer surpluses.
In a funny way - every dime that a corporation makes in 'profit' is a dime that you and I (as consumers) are losing out on in terms of consumer surplus.
An investor earning a return generally requires that present value does not account for all of the future profits. The parent I replied to claimed the exact opposite, that a valuation is based on all future profits.
For the investor ideally none of the future profits are captured in the present valuation. It's the battle between that position, and the company's desire to get as much capital for its equity as possible, that reaches the valuation.
Bingo. Valuations should be based on.... drumroll profits and retained value - EBITDA. When we started basing valuations on arbitrary "well if facebook are $100bn, X must be $y", we set sail for another glorious future of people losing their shirts.
Frankly, it just pisses me off - we're a profitable business which has grown 150% YOY for 6 years, and our value is barely £3M, based on our profits and growth. Why an infant company with little discernable revenue should have an astronomical value is beyond me.
The author's reasoning is deeply flawed - when projecting future earnings and determining the present day value of the company, you can't just add up the earnings. As money in the future is worth less than an equivalent sum of money today, you have to discount the future earnings using some sensible growth rate. See: http://en.wikipedia.org/wiki/Net_present_value
Well yeah, but they arguably should be part of the valuation model. I realize there's a lot of speculation, past investment history, etc. involved in the valuation, but at some point how much money a company is making and can realistically make should be part of the figuring.
That's a good point. I think you're referencing a Present Value calculation? My big issue with a lot of valuation techniques is they are based on exponential growth. That strikes me as overly optimistic, leading to decisions that overlook profitable businesses that do not grow exponentially.
You're taking the stance of investors are valuing Facebook and the like at X. Prove that's wrong. I think in general if you're going to value companies at significantly abnormal multiples of earnings. The burden of proof should fall on the person assigning those multiples.
But I'll play along anyway. I'll use Facebook as an example. One of the reasons for Facebook's lofty valuation is the very thin trading volumes. People are buying/selling very small $ amounts of Facebook stock in a private market at very high valuations. Imagine company X has one million shares of stock outstanding and I sell 1 of them for $100. Do you think company X is worth $100 million? If so I've got an endless supply of companies for you and I'll even be silly enough to part with them for the bargain price of $50 million. One of us will be rich...
So I contend that the published valuations are somewhat meaningless. The question then becomes what is a company like Facebook worth? Generally there are three main factors that determine a companies value. Tangible assets (cash in this case), earnings, and the value of retained capital. The first is easy and relatively insignificant in this case. The second is very hard, the third is just about impossible. My point is simply that high valuations relative to earnings should imply that there is a very high probability of significant growth in earnings. I think the people that believe in Facebook believe in what it could become not what it is today. If that's true, then the true profit engine is vaporware and it is therefore impossible to have enough certainty in a sufficiently positive future to justify the earnings multiple.
Now one example doesn't prove the point but I do think there is enough anecdotal evidence to justify thinking about the possibility of a bubble.
Not really. Valuations are base upon the expectation of future cash flows. That boils down to two things- how fast will those cash flows grow, and how much risk is their in those cash flows.
I don't have the energy to figure out the growth rate implied by a 50X multiple on sales, but I can assure you it is astronomical - unreasonably so.
But this doesn't mean that a company can't be worth more than its cash flows would indicate. Suppose the existence of a company (lets call it Instagram) threatens lots of cash flow of another company (for arguments' sake, call it Facebook). How much is Instagram worth to Facebook?
Instead of using Instagrams cash flow to value the company (easy! zero!). You have to use the incremental (and negative) cashflows of Facebook due to Instagram's existence. If Facebook stands to lose, a few hundred million a year to competition, suddenly, Instagram is very valuable indeed, but only to a small, small number of entities - Facebook, and probably Google.
In the end, it's all a speculative judgement call. But don't fall into the trap of evaluating small startups based on their own cash flow.
There's a lot wrong with this, but I'll just say that there are many more than two ways to value a company, and if you used the first type he cites (taking the net present value of future profits) you are effectively ignoring any assets the company currently owns, including IP, cash, property, plant, and equipment, short-term investments, long-term investments, just to name a few.
I think the OP is missing the point here, because there is much more than just profits when we talk about valuation. There is sales obviously, but assets too like more materials things (chair, buildings, etc) but also immaterial assets (employee, IP, so on).
On top of that, the whole situation (the when/how/where thing) is also important, like someone said, a glass of water worth much more if Zuckerberg is in the desert, than instagram at that moment...
Valuating a company just with profits (or users) is in my opinion, too simplistic and so undermine a little bit the argument here.
I'd suggest the valuations are based on perceived value by the investors. That's how we get insane valuations of $15 billion for Facebook when they were hemorrhaging money (not the case now of course).
Either way, I suspect its part voodoo and part negotiations when you're talking about speculative valuations like this
Valuations are also based on future potential (or lack thereof) as well. If a company is currently having a great quarter but there is news that might impact their next quarter, you can bet their stock will drop before their financials even take a hit. It works both ways.
Obviously based on their current financials this valuation is absurd, but given how fast they have grown and how many companies have picked up their product, I would put my money on them justifying this valuation in the future.
Under that premise, Facebook should have been valued at $200 billion at their IPO (or even earlier).
Google should have been worth $300 billion at their IPO in 2004.
Apple should be carrying a $20 trillion market cap using that calculation, pulling all of their future profits into their present valuation.
Investors do not normally reach a valuation for an investment today, based on profits ten years from now, with the expectation that the price paid today is equal to what the profits in ten years will justify. That's a recipe for not yielding any returns for ten years.
The point of a valuation is to invest capital into a company based on speculation of future returns to be yielded based on future profits, not to pay for all of those future profits with your investment today. The value is determined by the near-present estimation of what the business is worth, and with a potential bias elevating the valuation. The investor return comes from all of those future profits not being priced into the current valuation.
reply