How does a company get valued?
Valuations have always been a mystery to me. I never went to business school or worked for a big consulting firm. Everything I’ve learned about business, I’ve learned from building them myself, reading books, and seeking advice from mentors.
I knew that technology companies often get valued based on odd things like how many software engineers they have or which VCs are in a deal. I also knew that public companies get valued based on multiples of their earnings—for example, as of writing, the average price for an S&P 500 company is about 20x earnings. I had heard about terms in real estate like a “Price-to-rent ratio.” It wasn’t until I sold my business that I learned about the simple equation all investors use to value an asset.
Investors value everything from stocks, real estate, and private companies based on their expectations of future earnings. If an investor thinks that Google is going to continue to grow its profit—for example, by expanding to new markets, launching new products, or reducing its costs—they will buy its stock for a high price. If they don’t expect growth in earnings they will want to pay less.
Therefore Price (P) = Earnings (E) x Multiple (M)
The Multiple represents the value of a company beyond its earnings, which begs the question: what makes a company valuable?
Think about the Multiple of a company like a scorecard that shows how well its performing on a series of important metrics or key performance indicators (KPIs). For example, investors like to see growth so a company’s month over month or year over year growth rate is important. They also want to see high retention of customers so the retention rate or churn rate is also important.