What Is a Company Worth?

The main ways analysts value a business, from discounting future cash flows to comparing price-to-earnings ratios, and why valuations are uncertain.

Buying a share means buying a small piece of a company. How do investors decide what that piece is worth? Valuing a company is part science and part educated guesswork.

Market capitalisation

For a company listed on a stock exchange, the simplest measure is market capitalisation: the share price multiplied by the number of shares. If a company has 100 million shares trading at 50 dollars each, its market capitalisation is 5 billion dollars. This is what the market currently thinks the owners’ stake is worth.

Discounted cash flow

The most fundamental approach is discounted cash flow valuation. The idea is that a company is worth the cash it will generate for its owners in the future, adjusted for the fact that money in the future is worth less than money today.

Analysts estimate future cash flows year by year, then “discount” them back to today’s value using an interest rate that reflects risk. Riskier companies get a higher discount rate, which lowers their value. Adding up all these discounted future cash flows gives an estimate of the company’s value.

Multiples

A quicker approach compares a company with similar ones using multiples. The best known is the price-to-earnings ratio, or P/E: the share price divided by earnings per share. A P/E of 20 means investors are paying 20 dollars for each dollar of yearly profit. A high P/E usually signals that investors expect strong growth; a low one may signal doubts, or a bargain.

Two coffee chains

Coffee chain A earns 2 dollars per share and trades at 40 dollars, a P/E of 20. Coffee chain B earns 2 dollars per share and trades at 24 dollars, a P/E of 12. Investors are paying more for each dollar of A's profit. Perhaps A is opening new stores quickly and profits are expected to grow, while B's growth has stalled. Or perhaps A is overpriced. The multiple is a starting point for questions, not an answer.

Why valuations are uncertain

Every valuation depends on forecasts of the future, which are uncertain. Small changes in expected growth or the discount rate can change the result a lot. That is why analysts often disagree sharply about the same company, and why share prices can swing widely as expectations change.

Thinking a low share price means a cheap company

A share price on its own says nothing about value. A company with a share price of 5 dollars could be far more expensive, relative to its profits, than one with a share price of 500 dollars. What matters is the price relative to earnings, cash flow or assets.

Key takeaways

Market capitalisation is the share price times the number of shares.
Discounted cash flow values a company by its expected future cash flows in today's money.
Multiples like the P/E ratio compare a company's price with its profits.
All valuations rely on uncertain forecasts, so analysts often disagree.