The best indicator of a company’s value is its price-to-earnings ratio: At what price could you purchase the company? This price is the current valuation of the company. How does this price compare to the company’s present earnings, which are the company’s revenues minus its costs? The price or valuation of a company should bear a reasonable relationship to its earnings. For some companies, a case can be made that its future earnings might rise significantly, so that its current price or valuation should should be higher than its present earnings would otherwise justify. For a publicly held company, the price-to-earnings ratio is easy to calculate: The price of a share of the company tells you what is the company’s price or current valuation (you multiply the price of a common share by the number of outstanding common shares to arrive at the company’s current valuation, but the formula becomes more complicated when the company has also issued one or more classes of preferred stock). A publicly held company’s pre-tax earnings must be publicly disclosed in periodic reports that are not only published online but also analyzed by experts who do this sort of thing for a living.
Many high-tech companies and investors have completely lost sight of these fundamental axioms of business valuation. A high-tech company, like all other companies, is never immune from the ordinary laws of supply and demand, and over the long run its value will inevitably depend on the following circumstances: What products or services does this company provide? How much does the company charge for its services or products? What is the long-term demand for these services and costs? Who else can provide them? What costs are incurred to provide these products or services? These questions shed light upon the company’s expected or probable future earnings. Present earnings are hard data. The price, or valuation, of a company must bear a reasonable relationship to its present earnings or in some cases its likely future earnings.
Conversely, a company might enjoy excellent earnings, but face the likely prospect of imminent or eventual ruin. Its present valuation would have to be lowered despite its present prosperity.
Lose sight of these basics, and you will likely lose your shirt. Experts take these basics and work wonders with them. But they never lose sight of them, or they are not experts, but rather the peddlers of fairy tales that are calculated to impose upon the credulous.
William Markham, © 2014.