Financial Engineering

Finance Allah shmoop What are valuation analysis formats and ratios

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

s Okay but investors want to know what percentage of

the company there ten million bucks will buy So somebody

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

to be some exercise here which delivers an actual number

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

is worth X Well in real life the most sophisticated

valuation format lives in applying a discounted cash flow analysis

model Yeah go watch are most excellent video directed by

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

it won the Golden Mullah Award back in two thousand

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

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

profits like into the future Cash profits Five million next

year Ten million The next eighteen million accents sold for

one hundred million the next Then all those cash flows

or discounted back or divided by one plus the risk

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

get on your cash just by investing in U S

Government bonds plus risk Got it So that is risk

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

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

you are investing in government bonds when you invest in

equities like this right So if the risk free rate

is in a three percent like a five year T

Bill or something like that then you might pile risk

on top of that of saying six percent or ten

percent or twenty percent a year And the certainty of

that ten million box in profits in two years changes

a lot and then that hundred million at the very

end Well it might have huge discounting like be divided

by one plus the risk free rate plus a huge

risk premium act on in the denominator making one hundred

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

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

say thirty percent added to the risk free rate and

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

power Yeah a lot of discounting that it looks like

this You got one point Oh three plus point three

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

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

and give that a huge haircut But okay okay this

is a sophisticated Wall Street e way of valuing companies

There are simpler methods Multiples of sales is another one

that while people use And yes of course we have

an entire video on that one as well A company

has highly volatile profits like this is kind of company

that would use a multiple of sales valuation positive twenty

percent margins in great times negative fifteen percent margins in

bad times and an average over a decade of statement

of ten percent margins So on five hundred million of

sales it might on average have fifty million in net

profits and the average grows over time But the company

quote should unquote trade at a market multiple minus two

turns or something like that Or set another way if

the S and P five hundred straining at sixteen times

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

should trade it fourteen times Well fourteen times fifty is

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

times sales Wealthy calculation then revolve around sales instead of

profits usually since year after year profits are yeah all

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

go up three percent in Goodyear and down to percent

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

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

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

their free profits or cash into growth anyway So you

can imagine the same system applying to things like multiples

of gross margin for multiples of operating margin like pre

tax profits With the basic idea being that the closer

you get to the top line sales number usually the

less volatile those numbers on a year in year out

basis are and then the easier the valuation remains to

dial in structurally well cash flow multiples are good delimit

er zzzz Well think about how quote phantom depreciation unquote

works in clouding the true earnings Pictures of things like

a factory that cost a billion bucks to build and

is being depreciated to zero over ten years might carry

an earnings hit to the income statement of well a

hundred million bucks a year in straight line appreciation It

takes the eighty million in profits the company is making

toe being an accounting loss of twenty million dollars So

how does that work Well you thought you were making

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

got to depreciate one hundred million for that factory You

lavished Tobi right Well the cash the company produces is

its cash flow like from progressive Yet you know her

and backing out that appreciation gives a much clearer picture

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

e Its value meaning you pay a whole lot more

attention to that eighty million dollars in profits Then you

do the twenty million in losses But this valuation method

becomes extremely useful in cases where that factory being appreciated

to zero in ten years will in fact last more

like forty years and even then not be worth zero

So we have discounted cash flow We have multiple of

sales We have multiple of cash flow And then of

course the stalwart multiple of earnings or price to earnings

ratio as a basic valuation format or racial or structure

that drives the lives of oh so many investments P

ratios are probably the most common evaluation metric Whatever dot

com will earn after everything appreciation included a dollar next

year a dollar twenty the following year and a dollar

forty the next It trades this moment for twenty bucks

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

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

one point four times at the following years And yet

you get the picture It looks like that Well the

price to earnings multiple usually goes down over time because

well most companies actually grow their earnings over time The

Gatun here is that companies often carry cash and or

debt So if a company has ten dollars a share

in debt and four dollars a share in cash well

then its price to earnings ratio is while still twenty

But it likely has Mohr volatilities in its movements as

the debt is well kind of like gasoline on a

fire when things go well or poorly So yeah those

were the most common methods of assessing the value of

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

all of them with many grains assault Although uh well

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