[Editor’s Note: This is an excerpt from “Business Acumen for Strategic Communicators: A Primer.” You can purchase the book here and Ragan/PR Daily readers receive a 30% discount with the code BUSINESS30.]
There are many different financial valuation metrics and models that businesspeople, investors and other financially oriented stakeholders pull from financial statements to assess the current and future potential value of a business.
A valuation is an estimation of the economic worth of a business asset, unit or the entire enterprise. For publicly traded companies, the company’s stock price changes each trading day, thereby providing a near real-time view of the company’s ascribed total market value. For private companies, share ownership is more difficult to value due to the absence of a public market for the company’s shares. Private companies may hire an outside independent party, such as investment bank, to conduct a valuation analysis. Public companies also hire bankers to conduct such analyses.
Many financial valuation metrics and concepts are beyond the scope of this book. A more detailed knowledge of valuation metrics and concepts are probably only needed for those communication professionals working in investor relations, financial communication or another finance-intensive specialty area. However, any strategic communication professional, particularly those working in and with corporate communication and corporate affairs teams and/or with public company clients, would meaningfully benefit from understanding at least these three financial valuation concepts:
- market capitalization
- enterprise value (EV)
- P/E ratio
Market capitalization, also known as simply “market cap,” is a measure that determines the total market value of a company. Market cap is calculated by multiplying a company’s stock price at a certain date in time by its total number of issued shares outstanding. As you may recall, the shares outstanding figure is typically provided at the bottom of the income statement. For public companies, a firm’s stock price is often published on the investor relations section of the corporate site, as well as on many financial news and information websites, such as Bloomberg, CNBC.com, MarketWatch, WSJ.com or Yahoo! Finance. Stock charts use the stock price to provide a graphical representation of a company’s stock price performance over time. It is important to note that a stock chart does not directly display a company’s revenues or earnings performance—only its stock price.
As of year-end 2019, Alphabet had a market capitalization of nearly
$934 billion, making it one of the world’s most highly valued companies by market cap. This is based on Alphabet having approximately 698.6 million shares outstanding as of year-end 2019, multiplied by Alphabet’s closing stock price on December 31, 2019 of $1,337.02 per share.
Enterprise value (EV)
While market cap is a widely used valuation metric, it also has its limitations. Market cap is only based on a company’s equity value; it does not take into account a firm’s cash position, debt outstanding and any preferred stock issuance. EV, a more comprehensive measure of company value, takes these variables into account and represents the minimum price someone would have to pay if they wanted to acquire the entire company. For example, there are firms that carry significant amounts of outstanding debt, so valuing such companies based on just market cap (i.e., equity value) would paint a misleading picture.
Alphabet ended 2019 with an EV of nearly $806 billion. This is based on the company’s market cap of almost $934 billion plus total debt of just around $4.6 billion subtracted from cash, cash equivalents and marketable securities of around $132.8 billion.
The P/E ratio is perhaps the most widely used financial metric for valuing a company. The P/E ratio is sometimes called “the earnings multiple.” This ratio is the company’s stock price divided by its earnings per share (EPS). The P/E ratio tells an investor, a businessperson, or anyone else interested in a com- pany’s finances how much value the stock market is assigning to a company’s current or projected future earnings on a per share basis. Valuation metrics such as the P/E ratio allow for apples-to-apples comparisons of companies’ stock.
For example, a stock priced at $5.00 per share isn’t necessarily “cheap” from an investment perspective, just as a stock priced at $500 per share isn’t necessarily “expensive.” To make an accurate comparison, an investor must know how much (or how little) earnings are associated with each company’s share of stock. P/E ratios allow for this important valuation comparison between companies across industries, or even the overall stock market. This is the same idea behind not just looking at the price of two items of different sizes on a grocery store shelf, but rather looking at the price per ounce of both items to get a direct comparison of value.
Alphabet’s stock price for year-end 2019 was $1,337.02, which, when divided by its 2019 diluted EPS of $49.16, gives the parent company of Google a trailing P/E multiple of 27× earnings. For fiscal year 2021, Wall Street analysts expect Alphabet to post EPS of around $56.00. Using the same stock price and this EPS estimate gives Alphabet a forward P/E of 24× earnings. For comparison, the historical average P/E ratio of the information technology sector and the communication services sector is around 20× and 16×, respectively. By these comparisons, Alphabet shares could be viewed as “overvalued.” On the flipside, investors generally are willing to pay more for market leaders, particularly those that generate fairly consistent earnings growth over time, such as the market-dominant Alphabet.
Besides the P/E ratio, there are a range of other ratios that use a company’s stock price, along with another financial metric, to calculate a valuation measure. This includes the price-to-sales ratio and the price-to-earnings growth ratio. Companies are also valued on multiples of EV using ratios such as enterprise value-to-revenue and enterprise value-to-earnings before interest, taxes, depreciation, and amortization.
Matt Ragas is an associate professor of public relations and corporate communications at DePaul University. Ron Culp is the professional director of the graduate PR and advertising program at DePaul University.