Eli5: How can large companies be worth (valued at) so much when they do not make any net profit?
In: 7
Because they’re spending all the money they make to make themselves even more valuable.
If you started a business in your garage, and took all the money you made and bought land and a building to be your new headquarters, you’ve added assets to the company’s value while generating less profits (because you used the profits money to buy the stuff).
The company is more valuable though because it owns more stuff of value.
The evaluation also includes all assets including physical stuff the company owns as well as the value of intellectual property and patents the company holds.
* Lots of people will tell you it’s because there is the potential for profit (and thus dividend payments) in the future.
* But the real truth is because lots of investors know they can convince other people to buy their stock at a higher price.
* And the best way to get people to do that is to play along with the idea that companies that do *this* or *that* are very valuable and we should all buy stock in them.
If you are asking about the current situation with Twitter, and related companies then you are not the only one asking this question. Even experienced financial analyzers have no idea why some people think these companies are worth as much as they are.
But there are companies which are worth way more then what their net profit would have it. The idea is that while they might not be profitable now, and even run a huge loss, they are building up very valuable assets which will bring huge profits in the future. For social media sites their assets will typically be their brand and their users and network. And if this gets big enough you can make huge profits in advertisements, premium services and user data. So typically a company spend a lot of money in the startup phase, level off at the huge growth phase as they focus on growing as big as possible, and then make a lot of money when they can not grow any more and end up selling out.
The value of a firm is all of its future cash flows (cash in minus cash out) discounted to the present.
Getting to this value of course requires conjecture, and investors will disagree about what those future cash flows might be. Those who believe they will be higher will buy stock; those who think it will be lower will sell it. The balancing point between the two determines the price of the stock, and the price of stock * outstanding shares is the market valuation of the company.
The key word you are missing after profit is “yet.”
Some industries have incredible startup costs, like a gas station for instance. You have to dig in the ground and install a new gas main, as well as rent a building and pay a store clerk. In the first year, this may not be a profitable business. But in the 6th year?? It very well may be. Apply this on a larger scale, and you may see a company that reports losses of $1/share, now going down to .50/share, suddenly the company is breaking even and the next few years has turned profitable. All that goes into what makes the “valuation” of a company, if investors believe one day it will be worth more than it is now then it has value.
Because investors think the company will be valuable in the future. They believe that, at some point, either somebody will buy the company or the company will start to make a net profit.
you calculate value using future earnings 10 years ahead.
no earnings? then you use a different calculation vs companies with earnings
How can a college education be considered valuable when it costs a hundred thousand dollars and four years of your life? The answer is the same for both question: Because the money you’re spending now is expected to pay off more in the future.
If you had a way to get back $20 next year for every $1 you spent today, how much of your money would you be pouring into this investment? Well, that’s basically the same kind of logic that companies which are not posting profits are operating on: They’re re-investing profits into the business, so as to be able to make more money going forward.
A company is worth whatever someone is willing to pay for it.
Different investors have different ways to determine what they think something is worth.
In a perfect world, that would be based on some rational calculation of discounted expected future cash flows (how much money they will eventually make, and when) combined with the physical assets the company owns (cash, real estate, equipment). People will disagree about the value of both of these inputs, so there is almost always price fluctuation as people adjust their inputs. In reality, because people and investors are human, markets don’t exactly follow the rational math and emotion comes into it. A great salesman as a CEO can increase value if someone buys the message and the vision.
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