Have you ever wondered what your business is worth, or how, for that matter, that value is determined?
Generally, the value of a business is based on its ability to generate earnings, more specifically, free cash flows, most often defined as excess cash earnings, which are not needed to operate the business. Most often, particularly for publicly-held companies, a shortcut is used to express this value as a multiple of earnings (i.e. price/earnings, or "P/E ratio").
If your company earned $100,000 and its value is determined to be "5 times earnings," your company would be worth $500,000 (its P/E ratio would be 5).
Using a real example, in round numbers, Google's market as value as of this writing is approximately $150 billion. During its most recent fiscal year, Google earned $6.5 billion, yielding a P/E ratio of 23. In other words, Google's market value, which is a function of its ability to generate earnings, is equal to 23 x $6.5 billion, or $150 billion.
Of course, the preceding illustration begs the question: How is the earnings multiple of 23 determined? Why is it not 10 times earnings, or alternatively, 40 times earnings?
The short answer is: "Because that is the price a willing buyer will pay today, as well as the price a willing seller will accept today."
However, there is an enormous volume of finance literature devoted to valuation, from which shortcuts like the P/E ratio are derived. Without getting into the math, a company's value is basically a function of:
(1) Future cash flows – the free cash flows it is expected to generate in the foreseeable future;
(2) Growth rate – the anticipated rate of growth of those cash flows over time; and
(3) Return on investment – the return a prudent investor would expect to receive based on the riskiness of the investment.
An entire field of finance is devoted to business valuation. As a result, there are other factors to consider, other methodologies, and different terminology, but these are the basics.
Future cash flows
Compare Company A to Company B. If A's future cash flows are expected to exceed those of B, it makes sense that A would command a higher valuation.
Growth rate
Similarly, all other things being equal, it also makes sense that A would be valued higher than B if the expected rate of growth of A's cash flows is greater than the growth rate expected for B.
Risk and rate of return
Risk is the primary determinant of an investor's required rate of return. It makes sense that investors, and people, in general, prefer less risk than more. It also makes sense then, that a rational investor would demand a higher rate of return for investing in a venture with more risk.
An example illustrates this concept:
Assume that you lend $100 dollars to a friend who promises to pay it back in a year, with interest. Assume further that your friend lives a relatively stable lifestyle, has a good job, manages his money well, and has always paid you back. Let's call him Joe. Now compare Joe to another friend, Jack, who is often unemployed, tends to spend his money foolishly, and has been known to be a ladies man, a drinker and a gambler.
Notwithstanding the fact that Jack is more fun at parties, which one would you prefer to lend the money to? Obviously, Joe, because he is the one more likely to repay the loan on time. Taking it one step further, if both Joe and Jack needed to borrow $100, you might require that Jack pay you back at a higher rate of interest than Joe pays, because of the additional risk involved in lending to Jack. In essence, the higher the risk, the higher your required return.
You may be asking, "Everything you're talking about occurs in the future, What is the value of my company today?"
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