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Finance Allah shmoop What are valuation analysis formats and ratios

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It's a thing dot com It sells Who's ima wa

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s Okay but investors want to know what percentage of

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the company there ten million bucks will buy So somebody

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has to know what it's worth and why There has

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to be some exercise here which delivers an actual number

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that says at this moment it's a thing dot com

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is worth X Well in real life the most sophisticated

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valuation format lives in applying a discounted cash flow analysis

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model Yeah go watch are most excellent video directed by

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Martin Scorsese on that topic If you haven't seen it

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it won the Golden Mullah Award back in two thousand

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eighteen Well if you haven't seen it the notion is

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that company's heir valued as a stream of their cash

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profits like into the future Cash profits Five million next

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year Ten million The next eighteen million accents sold for

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one hundred million the next Then all those cash flows

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or discounted back or divided by one plus the risk

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free rate I'ii uh you know the rent You could

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get on your cash just by investing in U S

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Government bonds plus risk Got it So that is risk

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that the ten million of cash profits doesn't in fact

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happen in real life like you're taking more risk than

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you are investing in government bonds when you invest in

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equities like this right So if the risk free rate

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is in a three percent like a five year T

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Bill or something like that then you might pile risk

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on top of that of saying six percent or ten

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percent or twenty percent a year And the certainty of

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that ten million box in profits in two years changes

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a lot and then that hundred million at the very

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end Well it might have huge discounting like be divided

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by one plus the risk free rate plus a huge

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risk premium act on in the denominator making one hundred

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million a very small number like it's very risky So

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maybe that discount rate ends up being I don't know

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say thirty percent added to the risk free rate and

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it's four years out So it's taken to the fourth

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power Yeah a lot of discounting that it looks like

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this You got one point Oh three plus point three

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Oh it's one point three three then to the fourth

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power that you're going to divide into one hundred million

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and give that a huge haircut But okay okay this

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is a sophisticated Wall Street e way of valuing companies

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There are simpler methods Multiples of sales is another one

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that while people use And yes of course we have

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an entire video on that one as well A company

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has highly volatile profits like this is kind of company

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that would use a multiple of sales valuation positive twenty

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percent margins in great times negative fifteen percent margins in

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bad times and an average over a decade of statement

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of ten percent margins So on five hundred million of

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sales it might on average have fifty million in net

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profits and the average grows over time But the company

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quote should unquote trade at a market multiple minus two

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turns or something like that Or set another way if

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the S and P five hundred straining at sixteen times

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earnings well then maybe this crappy company that's highly cyclical

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should trade it fourteen times Well fourteen times fifty is

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seven hundred and note that that's about one point four

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times sales Wealthy calculation then revolve around sales instead of

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profits usually since year after year profits are yeah all

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over the place where sales are relatively steady like they'll

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go up three percent in Goodyear and down to percent

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of badly or something like that So that's a multiple

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of sales valuation format It's often used for early stage

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companies who really don't have profits and would reinvest all

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their free profits or cash into growth anyway So you

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can imagine the same system applying to things like multiples

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of gross margin for multiples of operating margin like pre

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tax profits With the basic idea being that the closer

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you get to the top line sales number usually the

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less volatile those numbers on a year in year out

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basis are and then the easier the valuation remains to

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dial in structurally well cash flow multiples are good delimit

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er zzzz Well think about how quote phantom depreciation unquote

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works in clouding the true earnings Pictures of things like

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a factory that cost a billion bucks to build and

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is being depreciated to zero over ten years might carry

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an earnings hit to the income statement of well a

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hundred million bucks a year in straight line appreciation It

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takes the eighty million in profits the company is making

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toe being an accounting loss of twenty million dollars So

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how does that work Well you thought you were making

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eighty million in net profits but it turns out you've

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got to depreciate one hundred million for that factory You

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lavished Tobi right Well the cash the company produces is

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its cash flow like from progressive Yet you know her

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and backing out that appreciation gives a much clearer picture

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of the company's expected profit ability in the future i

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e Its value meaning you pay a whole lot more

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attention to that eighty million dollars in profits Then you

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do the twenty million in losses But this valuation method

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becomes extremely useful in cases where that factory being appreciated

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to zero in ten years will in fact last more

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like forty years and even then not be worth zero

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So we have discounted cash flow We have multiple of

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sales We have multiple of cash flow And then of

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course the stalwart multiple of earnings or price to earnings

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ratio as a basic valuation format or racial or structure

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that drives the lives of oh so many investments P

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ratios are probably the most common evaluation metric Whatever dot

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com will earn after everything appreciation included a dollar next

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year a dollar twenty the following year and a dollar

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forty the next It trades this moment for twenty bucks

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a share or twenty times this year's earnings That's twenty

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over one point two times next year's earnings twenty over

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one point four times at the following years And yet

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you get the picture It looks like that Well the

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price to earnings multiple usually goes down over time because

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well most companies actually grow their earnings over time The

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Gatun here is that companies often carry cash and or

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debt So if a company has ten dollars a share

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in debt and four dollars a share in cash well

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then its price to earnings ratio is while still twenty

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But it likely has Mohr volatilities in its movements as

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the debt is well kind of like gasoline on a

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fire when things go well or poorly So yeah those

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were the most common methods of assessing the value of

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a company or a stock and you've got to take

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all of them with many grains assault Although uh well

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It's much easier if you just have one of these 00:06:07.671 --> [endTime] things to assess

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