PRINT, PDF, EMAIL

© 2017, by Daniel T. Jordan, ASA, CBA, CPA, MBA

The value of a company is typically determined by the net earnings of the company. The higher the profits, the higher the value. A frequent question asked is how to value a profitable company if the firm does not show significant profits because Management chooses to reinvest the profits to achieve higher growth.

Growth stocks for instance are company stocks that tend to increase in capital value rather than yield high income. The shareholders of those stocks prefer the growth in stock value rather than earning dividends.

Many eCommerce businesses and early-stage companies do not show much profit but are indeed very profitable. They just do not show the profits because the profits are reinvested so they can grow even more in future.

Thus, the question arises how to value those companies? Again, these companies are not only potentially but actually profitable.

In this blog, I will present three ways how to value this type of company:

1. We run a discounted cash flow (DCF) model based on projections provided by the Company’s Management. The projections have to go far enough out in the future to capture the growth that will be achieved through reinvestments. This way we account for the growth that is included in the future cash flows. The future cash flows are then present valued as of the valuation date.
2. If the DCF model is not practical because no projections are available or too subjective, we need to make adjustments to the current financial statements by adding back the reinvestments to the net earnings. In other words, we value the Company as if the reinvesting of the profits is not happening. This way the value of the Company is determined based on the profits that exist today.
3. Another way is to value the Company based on sales instead of earnings. If the earnings do not represent the true earnings power of the Company, then it is incorrect to value the Company based on earnings. We would rather look at the price/sales multiple.

The same is true if the buyer is a strategic buyer who is diversified and can generate synergies through the acquisition of the subject company. In such a case, the buyer is willing to pay a premium over Fair Market Value. We call the value “Investment Value” or “Strategic Value”. The multiples are much higher in such cases. Investment Value to a strategic buyer is almost always higher than Fair Market Value. Here, as well, there are three ways to go about this:

1. Either the projections need to be adjusted by increasing sales or lowering the costs to account for the economies of scale.
2. Or we add a strategic premium at the end of the valuation.
3. Or the valuation is based on sales instead of earnings. The price/sales multiple is derived from comparable transactions in the marketplace.