How to Value a Business

How do investors determine what a business is worth?

Let’s break it down by getting back to our example of Best Coffee Shop.

Imagine that it makes $20,000 in profit each year, which equals $1.00 per share in earnings each year. Let’s say the profits don’t change; they are exactly the same each and every year.

Now, if we take a look at the company’s financials for the next 10 years, here is what we’d see.

When looking at such results in earnings per year, ask yourself, how much would you be willing to pay to own a share of Best Coffee Shop?

Let’s imagine three completely different scenarios of how much you could pay to own one share and how it would affect your return on investment. To establish that, we have to divide the earnings per share by the price that you paid for one share.

Scenario 1. Imagine that you are willing to pay $2.00 for one share. You will get 50% return on investment in only one year, which is extremely high. Investing in this company, which allows you to receive 50% return, would be a great financial decision, especially when comparing it to keeping your money in a savings account at a bank earning 1% per year. Which option would you choose?

Investing in Best Coffee Shop at $2.00 per share would be an amazing purchase price for the buyer, however on the other hand it would be a pretty bad price for the seller.

Scenario 2. In our second scenario imagine being so desperately interested in owning Best Coffee Company’s stock that you are willing to pay $1,000 for one share. After a shareholder agrees and sells it to you, your return on investment will be just 0.1%.

Divide the earnings per share by the price that you paid for one share. Here it is, a very low return on investment, compared to keeping your money in a bank account where you could earn a 1% return, which is 10 times higher.

In this case you probably wouldn’t even bother buying shares of Best Coffee Shop. With just a $0.1 return on your investment, it would be a terrible deal for the buyer to purchase shares at $1,000 per share. However on the other hand it means that it would be a wonderful price for the seller.

Scenario 3. In our third scenario imagine that you are willing to pay $10 per share of stock. You would get a 10% return on investment, which is the most reasonable price for both the buyer and the seller. The buyer would earn a higher return than they could earn by keeping their money in a saving’s account, while the seller would also get a decent price on the stock.

These scenarios are the best examples to show you how shares are valued. Since buyers want the lowest price possible so they can earn a higher return in the future, and at the same time sellers want the highest price possible so they can make the most money from their investment, it’s the balance between buyers and sellers that determines the value of shares.

Primary factors to consider when valuing a business

There are two primary factors to consider when establishing what a business is worth:

• How much profit a company is expected to earn in the future.
• How much investors are willing to pay to buy those earnings today.

There are still many people forgetting that you can’t have a market price unless both buyer and seller agree on the price, which is vital to understand as a principle.

What is the price-to-earnings (P/E) ratio?

As we established, $10 per share was a fair price for Best Coffee Shop, which enabled the buyer to earn a 10% annual return on their investment.

Another way of saying it would be that the buyer and seller agree that $1 in earnings per share from Best Coffee Shop is currently worth $10 in market value as of today.

Investors would call this the Price-To-Earnings (P/E) ratio. Price-to-earnings ratio divides the price per share by the earnings per share.

Investors would use the term P/E to describe that Best Coffee Shop is currently valued at “10 times earnings” since its current P/E ratio is 10.

There are a lot of ways for investors to value businesses, and the P/E ratio is one of the most commonly used methods to figure out a company’s current worth. It also makes it easier for investors to compare opportunities with each other.

However, keep in mind that the P/E ratio isn’t always useful and there are going to be certain exceptions where it’s not applicable to value a business. For example, when a company is growing rapidly and doesn’t have any earnings yet or a company is in an industry which is risky and will possibly be gone within a couple of years.

The lower the P/E ratio is, the cheaper a company is to buy, and on the other hand the higher the P/E ratio is, the more expensive a company is to buy.

For example, if the P/E ratio of Best Coffee Shop is 10 and the P/E ratio of Starbucks is 20, then you could argue that Best Coffee Shop was a more attractive investment than Starbucks, excluding other factors. Simply because Best Coffee Shop’s P/E ratio of 10 is cheaper than Starbucks P/E ratio of 20.

Does growth change a company’s value?

To answer that question, let’s look at our company, Best Coffee Shop, and summarize what we already know.

The company makes $20,000 in earnings each year, which equals $1.00 in earnings per share. Moreover, the P/E ratio of 10 is fair both to the buyer and seller, meaning that one share of the no-growth Best Coffee Shop would be worth $10 per share.

However, key information is that Best Coffee Shop’s goal was to go public so it can open one new store per year and grow its business. Let’s assume that each of those stores makes $20,000 in earnings each year. Knowing that, this is what the financials would like for the next 10 years.

So, if the P/E ratio of Best Coffee Shop was always fixed at 10, how much would one share of this company be worth in year 10? The answer is $100.

A company that is producing higher earnings each year compared to a company which is not growing and makes the same amount of earnings each year, is a much more attractive business to own and invest in.

A business that is growing and producing more earnings usually can share bigger profit streams with its owners. This means that investors should be willing to pay a higher P/E ratio for a company which is growing than for a business that is not.

Now you know the basics of valuing a business, be sure to read the next part where we explain why the stock market and stock prices go up and down.