The company valuation and the profit multiple – Mr-Market markets, stock exchange, trading, economy

You know what P/E, KUV, P/S mean and what they don’t mean? Really?

That may well be and then I congratulate them personally. But I say it frankly and freely, when I see how the majority of normal investors argue on stock market Twitter, then exactly this understanding is missing, because things are not as interpreted by “common sense”, which is often on the wrong track on the stock market anyway.

Let’s take a fundamental look at the issue.

First of all, “multiple” simply means “multiple”, so we are talking here about a company value as a multiple of earnings. And if the company is listed on the stock exchange, the market capitalization – which is calculated from the price x the number of shares – is the company value and the so-called P/E ratio or P/E is the “profit multiple”.

In the following I will work with examples and have to simplify the very complex reality of company valuations.

The following simplification rules apply here:

First, there are many ways to value a company, especially in off-market M&A, and depending on the industry and the type of company (start-up or established company, for example), one must necessarily choose different approaches, because for a start-up, for example, a profit multiple makes no sense. For our purpose here, however, we are looking at *only* the earnings multiple, which for publicly traded companies is also called in German KGV or in American P/E (from Price vs Earnings).

Second, “profit” is a very broad word, even more so in times of IFRS. Are we talking about pre-tax or after-tax profit, EBIT, EBITDA or some other “creative” way of calculating profit? For our purpose here, let’s just call it “profit” and it doesn’t matter what it is exactly.

Third, tax effects are always an important factor when negotiating a company’s value as well; we’ll pretend here that there are no tax effects.

Fourth, future profits have to be discounted into the present -> because instead of investing the money for future profits, you could invest it. So, for our purpose here, we pretend that there is no interest rate and therefore no discount factor.

Fifth, the profit multiple can of course only be expressed as a P/E ratio for listed companies, because only there is a “price” that visualizes the value of the company on a daily basis. For our purposes and for simplification, I use the abbreviation P/E ratio here as a synonym for all profit multiples, including those of unlisted companies.

If we take all these preconditions for this thought experiment as given, we now have the basis to show quite simply what the market actually values with the P/E ratio (earnings multiple) and why.

Let’s make it concrete and imagine a concrete company that you – yes, exactly you – want to buy. You are in negotiations with the owner.

Company A

Company A has no business anymore, it is practically closed down, but the company still owns a lot of goods in the warehouse, which currently have a market value of 1 million.

What would you offer the owner for it?

First of all, there is no more multiple here, because within a year they will sell the entire stock.and there is no repeatable gain. So is the multiple here 1?

Of course not, because why would you go to the trouble of buying a company with goods at the market value of 1 million for 1 million? You do want to make a profit, otherwise there is no point in wasting your time and besides, you still have your own costs when you sell.

So you might offer 500,000 to the company owner, then add your costs on top of that and you are left with profit.

So the P/E ratio in the scenario of a company without any future is 0.5, so to speak, although this is a skewed formulation here because we are not talking about operating profit but liquidation of inventories – i.e. book values. But for the simplified representation here it is OK.

Company B

Company B has a very stable business, which is expected to remain stable for years and also the profit of 1 million per year will remain stable. But you can’t expect growth either, the company will probably just keep running.

What would you offer the owner in return?

Now you have to calculate how many years of profit you are willing to pay to acquire this company. In simple terms, these are the years you have to wait until you get a return on your investment.

Quite clearly, the more stable the business, the more years they are willing to wait. The more uncertain the business, but still with no growth prospects, the less they are willing to wait.

After all, with every year of “waiting” the risk increases in the abstract that something negative will happen after all and the business model of company B will be destroyed.

When such companies change hands in the private sector – i.e. what we call small and medium-sized businesses – P/E ratios (earnings multiples) of 4-7 have become commonplace, as you can also see -> here at the SME Entrepreneur Exchange.

So, as an example, you are willing to wait 5 years until your investment in the company pays off and so your offer to the owner of the company is 5 million.

Company C

If the old company owner manages to sell his company to the stock exchange at a P/E of 5 instead of selling to you, he has a good chance to get there rather a P/E of 7-12 for the same business, which is then paid by the subscribers at the IPO. This motivates to go public, but on the other hand the administrative effort and costs are so high that it is only really worthwhile for larger companies.

The difference in valuation is due, among other things, to the higher visibility of the figures of listed companies, with which also comes greater security for investors. And if you remember company B, you are willing to pay more if the profit development is more secure in the long run. In addition, the market provides you with many more interested parties in your company than you could achieve in a direct, off-market sale, and more demand means higher, enforceable prices.

Company D

In Company D, a founder with a brilliant idea sells you his company, which is currently making 1 million in profit. Due to the great business model and the strong growth, you can assume that the profit will increase strongly and double every 2 years, if not more.

Now it becomes quite difficult, because now you have to You make a lot of assumptions. Simply to say that is also a P/E of 5 is nonsense and the seller will not sell the company like that, because that is much too cheap.

Because not only the profit today is sold, but also the immense potential, which can generate a profit of 5 million in 5 years, for example. So you would get the company almost for free.

On the other hand, you can’t simply extrapolate the growth into the future, because with potentials there are immense risks and, by the way, *you* have to develop the opportunities first, the seller sells you only the present and not the future, which you have to conquer. And you don’t want to pay the seller for an entrepreneurial service that you have to provide in the first place.

In short, a potential is worth something, but it cannot simply be extrapolated indefinitely and must therefore be heavily discounted. And clearly, in the reality of the M&A business, a profit multiple for such a company is *not* an appropriate way to determine the value of the company, you then use other techniques. But as said above, let’s stick to the example here.

In the end, you might offer the owner a multiple (P/E) of 20 in private, and on the stock market you might call a P/E of 30 or 40. That makes sense.

So this company might go over the “counter” for 30 million and that’s mainly because of positive expectations.

Company E

Now we come back to Company B with its stable earnings, which in the over-the-counter environment you might have appreciated with a P/E ratio of 5.

But now the company’s CEO has an inconvenient truth for you. Yes, the company has stable profits and yes, they will pretty much last another 5 years, but all the company’s technology is outdated, competitors are coming and most importantly, there is a fear that the legislature will impose all sorts of levies and aggravations on the company’s business in about 10 years.

Do you still pay a multiple of 5? Absolutely not!

The reason to invest in the company is the future and with such a negative future expectation you will ask yourself if you want to invest in this company at all!

In reality, if you imagine the scenario real, you will probably not do it anymore – why waste time with it? And if you do, then for a multiple of 2 or 3, because the purchase only makes sense for you if you can be *really sure* to get your investment back via profits.

Transferred to the stock market, this information turns a company that may have been worth a P/E ratio of 12 into a P/E ratio of 6 or 7, i.e. a valuation without any future prospects.

So ….. I hope the point has been made.

You have seen that it is your *expectation* of the future that determines the price you are willing to pay for the company. Not the profits of the past, but the expected profits of the future!

In all the cases above, the present profits were 1 million, the difference in valuation is not the past, but the *future expectation*!

And the higher the P/E ratio (the multiple) you are willing to pay, the more positive your future expectation is and the more certain

he assumption is that profits will grow.

If this expectation is high, as in the case of company D, then you are prepared to pay a high multiple (P/E ratio). And otherwise not and if there is no more future, the valuation becomes more and more like that of company A, where you only use the value of the liquidation of the existing assets as a benchmark.

And still another important realization lies in above explanation: The P/E ratio is *no* yardstick for whether a share is attractive or not!

Because the P/E ratio only describes the consensus of discounted earnings expectations in the future, it is a snapshot. And whether the P/E ratio is 10 or 40, these expectations may turn out to be too high, too low or just right in the future.

So if you buy stocks with low P/E ratios, you are buying companies that the market doesn’t think have much of a future. No more and no less.

To believe that the market is wrong about this is rather naive without a really deep knowledge of the industry and company. It is possible to be smarter than the market when valuing individual companies, but this requires knowledge and experience in company valuations as well as intensive knowledge of the industry and the competitive environment. Ideally, insider knowledge as well.

The vast majority of investors who operate with P/E ratios and P/B ratios for the fundamental valuation of shares, however, do *not* have this sophisticated knowledge, especially since the time required for this is not even possible for investors with a job.

And publicly known fundamental data are also unsuitable as a basis for being smarter than the other market participants. Nevertheless, people are terribly fond of imagining it and writing long “analyses” because it serves their ego – we are all a bit “Buffett” and “investment heroes”, aren’t we?

So anyone who thinks that a stock with a P/E ratio of 12 would be “cheaper” than one with a P/E ratio of 30 has fundamentally failed to understand something, and unfortunately far too many continue to do so.

Both shares are rather valued exactly as the swarm intelligence market considers appropriate, taking into account all known facts. And this can turn out in *both* cases in the future as too optimistic or too pessimistic! In both cases, it is not clear in advance in which direction the market is wrong.

If you don’t believe that, you can compare Amazon’s P/E ratio over 20 years, I’ve often written about it….

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