Neil Patel

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If you’re thinking about selling your business, or perhaps purchasing one (or stocks of one) for yourself, valuation metrics will become incredibly important. These metrics are used to compare different companies on a variety of aspects, depending on the one you opt to use.  

These figures are primarily used when buying stocks within a company but are essentially a way for you to get an idea of the value of a business. Using these calculation methods, you can find out how your business performs against others within your niche. 

If you’re looking to acquire a company, these numbers can be used to identify a business that suits your style of investing, or see which acquisition would be most favorable. In this article, we take a look at the main types of valuation metrics while helping you to understand them. 

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    The Benefits Of Valuation Metrics

    As previously mentioned, these metrics are a great way to find out what a business is really worth. With an idea of the true value of a company, you can see whether or not you are overpaying for an acquisition or shares within it. As a business owner, using these metrics can help to ensure you do not sell your company short should the time come. 

    Valuation metrics can also be a tool for measuring the growth of your business over time. Potential buyers usually look for consistent growth over time, so if your figures are improving month on month, this is a good sign. With metrics that dip or stay the same over time, you can delve deeper into the issue and take the necessary steps to rectify it.  

    Overall, these numbers are incredibly useful to have for business owners and investors alike. They can help your decisions and allow you to spot problems for great levels of profitability. They will also prove vital for business fundraising. With the advantages discussed, let’s take a look at some of the most commonly used valuation metrics, as well as how to calculate each.

    Price To Earnings Ratio

    Price to earnings ratio looks at the current price of the stock in a company, compared to what this stock generates on a yearly basis. To calculate this, divide the current share price by the earnings. For example, if a stock currently costs $20 and earns investors $4 a year, the sum would be 20/4 or 5. 

    When broken down into simpler terms, this number is the amount an investor would be paying for a dollar of earnings. In the previous example, this is $5, leading to a 5-year return on investment. If this number is high, you might be getting better value elsewhere. A low number can mean that the stock is under-priced, potentially offering a lucrative opportunity.

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    The same calculation can be done when looking to acquire a business. Simply divide the asking price by the yearly earnings to find this number. High and low numbers have the same implications as previously mentioned, with lower numbers being a faster ROI

    Pros:  

    • Can be very useful when looking into a company that has consistent earnings, year on year
    • Of all the ratios mentioned in this post, price to earnings is by far the most used

    Cons:  

    • Doesn’t consider company outgoings. A business could be operating on a negative cash flow but still have an appealing price to earnings ratio
    • This type of valuation metric isn’t as effective for comparing businesses in different niches or industries

    Price To Book Ratio

    Another metric to take into consideration is the price to book ratio. This compares the current assets in a business to its current market capitalization. When calculating this figure, liabilities must also be taken into account, alongside the current stocks that are allocated to shareholders. The calculation is as follows: Market share price divided by the book value per share.  

    To find the book value per share, you have to take the current assets from total liabilities, before dividing this figure by the number of common shares. For example, if a business has $120,000 of assets, $20,000 of liabilities and 100,000 shares, the equation would be: (120000-20000) / 100,000 which comes out at 1 in this instance. If the market price of a share for this example company is $1, then the price to book ratio would be 1/1, or 1. 

    Any price to book ratio under 1 is seen as an incredibly attractive investment when purchasing stocks. This would also be the case for purchasing a business should the opportunity arise. A number under 1 essentially means that even if the business liquidates, there would, in almost all cases, be sufficient value within the company to ensure that all shareholders are paid back. 

    Pros:  

    • Often used to assess the safety of an investment, as it incorporates the amount of capital that can be generated immediately
    • Helps to clarify whether or not a business might be undervalued

    Cons:  

    • This figure can be diverse and change frequently. For example, if the company gains value, then this value would be lower. Adversely, when a company acquires more liabilities, this ratio would rise
    • Doesn’t take into consideration assets that have no tangible value, such as brand awareness, reputation, etc. 

    Price To Sales Ratio

    This ratio is often referred to as PSR, helps us to understand the number of sales each share is typically getting over a yearly period. To get this figure, simply divide the share price by the turnover per share. To get the turnover per share, simply divide the total turnover by the number of available shares. An example would be a company with a turnover of $120,000 a year, with 60,000 shares being sold at $1 each. First, we’d need to get the turnover per share, which would be 120,000 divided by 60,000, or 2. Then, we divide the share price of $1 by 2, giving us a price to sales ratio of 0.5.  

    Again, the lower this number the better when looking from an investment perspective. A number below 1 means that each share is generating more revenue than the cost of the share itself. Keep in mind however, that this is just the revenue of a company. Unlike price to book, it doesn’t take into consideration the cash currently available to the business.  

    Pros:  

    • This ratio is most commonly used for businesses that are not profitable, or those who are still in the phase of reinvesting earnings. It helps to give you an idea of how profitable the business could be if this capital wasn’t being used for growth or sustainability
    • Less susceptible to manipulation, especially when compared to the price to book ratio

    Cons:  

    • Profitability is not addressed in the calculation, only revenue. From an investing standpoint, you could be misled into thinking a stock or company is undervalued by solely using this metric

    Price To Cash Flow Ratio

    Cash flow is another important aspect of a business that ensures enough money is sustained for ongoing operation. Essentially, a business must have a set level of cash flow to manage everyday expenses. The useful part about using this ratio is that it factors in ‘non-cash expenses’ such as depreciation to the income of a company.  

    To get this ratio, you simply divide the current share price by the current operating cash flow per share. To get the second figure, divide the total cash flow earned (This is typically done for a 12-month period) by the number of outstanding shares. For example, if a company has a cash flow of $120,000 with 20,000 shares and a share price of $36, the calculation would be 120,000 / 20,000 / 36. In this case, the ratio would be 1.5. This ratio can be adjusted to value the business by dividing the total market value by the current operating cash flow. 

    Again, as is the case with all ratios mentioned in this article, a lower number signifies better performance of the business in question. Using our example, an investor within this company would be paying $1.5 for $1 of expected cash flow in the future. 

    Pros:  

    • The main advantage of using the price to cash flow ratio is that it cannot be easily manipulated. Money flowing in and out of the business is easy to identify, therefore it can offer a truer look into a business’s performance
    • The cash flow of a business can often tell you a lot more than sales or earnings alone 

    Cons:  

    • If not published, finding the operating cash flow of a company can be a time-consuming process
    • With many different types of cash flow, there may be discrepancies between calculations  

    Which Valuation Metric Should I Focus On?

    With all of these valuation metrics, is there a certain one that you should be focusing on? As a business owner, you should look to ensure that your business is performing in as many of these areas as possible. After all, you can never be sure which metric will appeal the most to a potential acquirer or investor. As previously mentioned, you can also use these metrics to spot growth in your business over time. Perhaps calculate these ratios every quarter, month, or yearly, to analyze your current position and identify areas that can be improved. 

    If you’re looking to invest in a company, it’s important to find a ratio that suits your style. Some cautious investors will use the price to book ratio for example, as this can be used to help evaluate how safe an investment is. Each valuation metric has its own pros and cons, as discussed, so finding the right match to your investment specifications is key. Can’t seem to identify which metric to use? It might be a good idea to use them all as a basis before making your final decision. 

    Metrics are everything to investors when you are raising capital from investors. In this regard, keep in mind that in fundraising, storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

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    Things To Consider When Using Valuation Metrics

    Of course, when using valuation metrics, there are other things to take into account. Here are a few worth mentioning: 

    Changing Over Time

    Depending on how often you are calculating these ratios, you might see large swings. This is typically the case if you’re working out each metric on a shorter time scale, such as quarterly. Some businesses are seasonal, with many of them performing differently throughout the year. For example, if the business you are evaluating sells physical goods, the ratio you get in the last quarter of each year may make the value appear higher than it really is.  

    While this doesn’t prevent the issue completely, taking a larger time period into account can help to average out the peaks and troughs concerning the performance of a business. Most experts would recommend using a 12-month trailing time scale for calculating these ratios. 

    They Shouldn’t Be Used Alone

    When making a decision to invest, or simply appraising a business, these metrics shouldn’t be your sole focus. Valuation metrics are a tool that work seamlessly with other appraisal methods, so using them alongside others can help to give you a better idea of the business’s true value. 

    You also shouldn’t forget about the ‘traditional’ ways of analyzing a company, if you are looking to invest. Doing as much research as possible is always recommended, looking at more than just the numbers associated with a company.  

    Metrics Don’t Factor In Growth

    Some investors will see a unique opportunity for a business to grow, which can in turn be their primary reason for investing. This isn’t factored in when using these metrics unless you input expected figures when calculating each ratio. Using expected figures are somewhat frowned upon by experts, however, as you are essentially adding an element of guesswork to a proven calculation. 

    You might enjoy the video below where I cover how to value your company.

    Valuation Metrics And How To Understand Them

    Hopefully, this article has cleared up the main concerns behind valuation metrics. By using the information provided here, you can now calculate four commonly used ratios and apply them to either your business or a business you plan on investing in. While valuation metrics can be incredibly useful, it’s important to use all the tools you have available to gain the best possible understanding of a business.

    You may find interesting as well our free library of business templates. There you will find every single template you will need when building and scaling your business completely for free. See it here.

     

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    Neil Patel

    I hope you enjoy reading this blog post.

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