If you’re an entrepreneur or an investor, you definitely need to know how to value a company based on profit.
Valuing based on profit is not my go-to method, because profit is a tricky number to use, as I’ll explain below. But, you should certainly know how to use it.
This comes in handy in negotiations or when you’re making a case for your business in comparison to your competitors.
To value a company based on profit, first, you gather the profit multiple of similar public companies.
Second, calculate the average and the median profit multiple from the data you gathered. This is the industry average you’re going to use.
Third, multiply that average profit multiple by the profit of the company you’re valuing. You can use trailing 12 months of profit or forecasted profit, but be consistent.
We’ll go into more detail below. Before we get into the details, let me explain the benefit of knowing how to value a company using profit.
Benefit Of Valuing A Company Based On Profit
If you’re a fan of the TV show, Shark Tank, you know that the Sharks often question the entrepreneurs why they think their valuation makes sense.
For example, in the ‘18 holiday episode of Shark Tank, Hire Santa company came into the tank asking for $200k in exchange for 10%.
That means Hire Santa valued their own company at $2 million. Is this a reasonable valuation? Let’s take a look.
Hire Santa’s revenue for the year was projected to be around $1.3 million. Their profit was projected to be around $500k.
That means Hire Santa valued their company at a 1.5x revenue multiple ($2 million divided by $1.3 million) and 4.0x profit multiple ($2 million divided by $500k).
With just this information, we can compare it to the industry standard. That’s what the Sharks and investors do when they’re gauging whether they’re investing at a fair price.
Hire Santa is basically a specialized, seasonal staffing firm. And, the average revenue multiple of staffing firms is 0.6x and EBITDA multiple is 4.5x.
NOTE that EBITDA (earnings before interest, taxes, depreciation and amortization) is the more standard number to use for staffing firms than profit. Profit multiple should be higher than EBITDA multiple, so for the sake of this example, we’ll assume that the average staffing firm’s profit multiple is 5.0x.
So, this tells us 2 things:
- Based on revenue multiple, Hire Santa is overvalued because Hire Santa’s valuation is at 1.5x revenue multiple, which is higher than the industry’s of 0.6x.
- Based on profit multiple, Hire Santa is undervalued, because Hire Santa’s valuation is at 4.0x profit multiple, which is lower than the assumed average staffing firm’s profit multiple of 5.0x. But it’s not that much off.
Based on this quick valuation scheme in isolation, we can argue that Hire Santa’s valuation of $2 million is slightly on the high side, but because Hire Santa’s profit is very good, it’s not unreasonable.
So, the Sharks/investors should seek to negotiate their investment so that the valuation is in the range of $1.5 million to $2.0 million, but it would be fair enough if they did invest at $2.0 million.
As you can see, the benefit of knowing how to value a company based on profit is that you can quickly determine the company’s value using a profit multiple.
This is very useful when you’re negotiating and when you want to call out someone’s BS.
Needless to say, if actual tender is involved, you should do a lot more due diligence and calculation than simply multiply the profit by the industry multiple.
How To Value A Company Based On Profit Using A Multiple
As illustrated above, one way to value a company based on profit is to use profit multiples.
That is, find the average of similar public companies’ market cap divided by their profit, to get the average profit multiple for similar companies. Then, use that number to multiply it to the profit of the company you’re valuing.
Another way to value a company based on profit is to use the discounted cash flow (DCF) method. This method is more involved in terms of projection and calculation, so I won’t focus on this method. Besides, DCF uses free cash flow instead of profit.
Back to the profit multiple.
Now, there are a few versions of profit multiple you can use.
Public Companies vs Precedent Transactions
The first is to either use the average industry multiple for similar public companies. With public companies, you can calculate the multiple by dividing their market cap by their profit. Then averaging or calculating the median of the multiples.
Or, you can look up precedent transactions, meaning the acquisition price of a similar company divided by their profit at the time they were acquired. You can gather that data and find the average or median of those multiples.
Public companies’ multiple is more readily available, so this is a more favorable method.
The benefit of using precedent M&A transaction multiples though is that they include a premium for the acquisition of the company.
As such, if you’re looking to value a company to sell it, then the premium in the multiples of precedent transactions is more comparable to use. That way, company’s valuation can reflect the premium as well.
Using Trailing 12 Months or Forecasted Year As Profit
You can either use the most recent 12 months (trailing 12 months) of profit or the next fiscal year’s projected profit. The benefit of using the forecasted year’s profit is that whatever happened last year that was unusual won’t be accounted for in the valuation.
On the other hand, using the trailing 12 months is more accessible, since this is data you already have. Forecasting always has a component of error.
Where To Get The Profit Multiple Data
Now you know that to value a company based on profit, you need the industry’s average multiple. So, where do you get this data?
As explained above, the profit multiple we are going to use to find the value of a company is based on public company data.
Analysts use paid databases such as Capital IQ or Bloomberg to obtain this data. These databases simply aggregate all the public companies’ financials and spit out the number for you.
But, we don’t roll like that here on microcap, because we are here for the little guys and we have better places to spend $24k a year (i.e. we can’t afford it…).
So, I’ll share with you 2 ways you can gather the profit multiple for free:
Nasdaq’s Stock Screener
Nasdaq has a stock screener tool that you can use for free.
Select the criteria for the size of the companies (i.e. market cap between $50 million and $200 million).
Select the industry or sector of the company you’re valuing.
Run the screen.
Then, edit the view to include their P/E multiple, which is price to earnings ratio, which is essentially market cap divided by profit (aka net income).
Then, calculate the average or median of the multiples in that list.
I’ve gone ahead and pulled up public microcap companies’ profit multiple from Nasdaq and calculated the average and median for each industry. You can download it here.
Professor Damodaran’s Website
Another place you can obtain the profit multiple by industry is on NYU Stern’s Professor Damodaran’s corporate finance data page.
This list calculates public companies’ P/E multiple by industry.
When I worked at a firm where I valued companies all day long, Professor Damodaran’s website was a godsend.
Let’s Break Down Another Shark Tank Example
In the same holiday episode of Shark Tank, Oat Meals asked the Sharks for $500k in exchange for 20%. So, the company valued themselves at $2.5 million. Worth it?
The company’s revenue for the year was $470k and the net profit was $47k.
Using the public company profit multiple from my Nasdaq stock screener list, I find that the “Foods – Natural Foods Products” industry had a median profit multiple of 18x.
[If you downloaded the spreadsheet, it’s in tab “PIVOT_PE trailing 12 months” in cell D103.]
So, you take the profit of $47k and multiply that by 18x.
That means the value of a natural food company with a profit of $47k is ~$850k.
So, the Oat Meals company really overvalued themselves.
Lori negotiated the valuation to $1.5 million by offering $500k for 33.3%. It’s still overvalued, but hey, being on Shark Tank will propel their growth.
But if Oat Meals wasn’t on Shark Tank, an investor should not invest in this company for more than at $1 million valuation.
Example Acquisition Multiples in 2019
- 45% of Acadian Timber Corp.’s shares were acquired in August 2019 for ~$125 million. Their latest annual net income (aka profit) was $13.4 million. So, on a profit multiple basis, they were acquired at a 21.2x multiple. They are in the forest products industry, and the industry average trailing P/E multiple for forest products is 24.9x, so their acquisition multiple was not too far off from the industry average.
- MNB Corporation, a regional bank, was acquired in May 2020 for ~$80 million and their latest annual net income was $3.6 million. So, they were acquired at about 22x multiple. The industry average P/E multiple for a regional bank is 15.4x. So in this case, the company was acquired at a higher valuation than the industry average, which could be due to many reasons but most likely that the buyers put a high value on MNB’s assets that could benefit them greatly.
Pitfalls of Valuing A Company Based On Profit
As you’ve read up to now, valuing a company based on profit is pretty straight forward.
You just have to obtain the industry’s profit multiple and multiply that by the company’s profit to get the valuation.
But, relying on this method only as a way to value a company is not advisable.
Here are some reasons why using the profit number is not reliable:
- Start-up companies don’t have profit. So, you can’t value the company even if you wanted to. And, just because their profit is 0, it doesn’t mean the company is worthless. They might be growing at a fast rate but just haven’t reached breakeven yet. They’re still paying back the initial start-up investment cost.
- Companies in some industries don’t have profit for a long time. For example, biotech or pharma companies pour millions of dollars into their R&D and clinical trials. Their profit is negative for years until they have a breakthrough and their drug is approved by the FDA. Only then, these companies will reach the commercial phase, and years after, will have positive profit. Until they reach that point, you can’t value new drug companies based on profit.
- Different stages of a company’s life cycle will have different profit levels. For example, a large mature stage company will have economies of scale and thus may have strategically minimized their overhead cost. Meanwhile, a small and young company might still be struggling with high overhead cost, so their profit margin may be lower. So, using a profit multiple from mature stage companies and applying it to a growth is not apples to apples.
- Below the EBITDA line, companies can manipulate numbers using different accounting methods, such as which non-recurring income or expense is recorded, and when as well as how fast depreciation and amortization is applied. These manipulations affect profit, so using profit is again, not a reliable apples to apples comparison between similar companies.
So, here’s a recap of all the jibber jabber above.
First, understand how to value a company based on profit. That is, find out the industry’s average profit multiple and multiply that to the company’s profit.
This will come in handy when you’re doing a quick calculation in your head of what a company’s value is.
Second, understand that using the profit is not a reliable measure to value a company.
So, although this method may be valuable for a quick determination of a company’s value, it is not enough to slap it onto a business plan slide and call it a day.
Thirdly, to get the industry’s average profit multiple for free, use Nasdaq’s stock screener or Professor Damodaran’s wonderful list of aggregated financial data.
I hope you found this helpful. Leave me a comment, a question, or a suggestion for a new post that you want to read. Thanks for reading!
Another great post
How come EBITDA multiples can vary so much? Staffing company of 4.5x and food company at 18x?
Does it assume that the moat or barriers to entry are so high in the latter that it justifies the much higher multiple (much lower risk)?
Hi Jon, thanks for your comment! Sorry for the late reply. That’s exactly one of the reasons. There are many reasons at play when it comes to dictating whether an industry’s multiple is in the higher range or lower range, including market trends, competitors, shifting needs of customers, projected growth rate of an industry based on the customer needs. Basically, it comes down to supply and demand. If you haven’t already, I’d recommend having a read through Michael Porter and the Porter 5 Forces to get a deeper understanding of competitive forces (link to the book here). And for projected industry trends, I tend to go to Ibisworld or CB Insights. Thanks for reading!
Superb post. One of the best available on these concepts online. I would appreciate it if you could share an example of let’s say 3-4 companies that got acquired in 2019. The study could mention what their financials were and the reasoning for the valuation that they were acquired. But overall! superb post!!
PS: Loved this line
But, we don’t roll like that here on microcap, because we are here for the little guys and we have better places to spend $24k a year
Thank you, Ankur! That is a great idea to add to the post. I’ve now added a couple of real life example company acquisitions and their profit multiples, Ankur. Thanks for the suggestion!