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Understanding the factors that make a company valuable

Updated: Apr 5

When it comes to investing in the stock market, there are many factors to consider. One of the most important is understanding what makes a company valuable and how it can become even more valuable over time.

What I am going to share with you is what I have read in Chapter 10: Earnings from the book One Up on Wall Street. Check out my other recommendations on books for successful investing here.

In this article, we will explore the basics of what makes a company valuable and what investors should look for when analysing a company.

What makes a company valuable?

When you invest in a company's stock, you are not just buying a piece of paper or a lottery ticket. You are becoming a part-owner of a business. As such, analysing a company's stock is similar to analysing any other business you might want to buy. At the core of a company's value are its earnings and assets.

Earnings are a company's profits. If a company is profitable, it can use those earnings to reinvest in the business, pay dividends to shareholders, or buy back stock. The more earnings a company has, the more valuable it is.

Assets, on the other hand, are what a company owns. This can include things like property, equipment, inventory, and cash. The more assets a company has, the more valuable it is.

How can a company increase its earnings?

If you want to understand how a company can increase its earnings, there are five basic ways to consider:

Reduce costs - By cutting expenses, a company can increase its profitability.

In 2018, General Electric (GE) announced a plan to cut $2 billion in costs by reducing headcount and restructuring its power business. This move was made in response to declining profits in their power division and a need to streamline operations across the company. You can also see this happening across various tech companies as they are cutting headcounts to reduce costs.

Raise prices - Increasing prices can lead to higher profits, but it can also lead to lower sales if customers find the prices too high.

Apple is known for its premium products and high prices, which have helped the company achieve record profits. In 2018, Apple released a new version of its iPhone, the iPhone X, with a starting price of $1,000. Despite concerns that the high price would turn off consumers, the iPhone X quickly became the best-selling iPhone model and helped Apple achieve record profits.

Expand into new markets - By entering new markets, a company can increase its customer base and potentially increase its profits.

Amazon has been successful in expanding into new markets, including cloud computing, streaming media, and grocery delivery. In 2017, Amazon acquired Whole Foods, a grocery store chain, in a move to enter the grocery market. This acquisition has helped Amazon increase its revenue and customer base, and it has allowed the company to offer a wider range of products and services.

Sell more products in existing markets - By increasing sales in existing markets, a company can grow its revenue and profits.

Coca-Cola has been successful in growing its revenue by increasing sales of its flagship product, Coca-Cola, in existing markets. In 2017, Coca-Cola launched a new marketing campaign, "Taste the Feeling," which aimed to increase brand awareness and encourage consumers to choose Coca-Cola over other soft drinks. This campaign helped the company increase sales and profits in existing markets.

Revitalise or close a losing operation - If a part of a company is losing money, it may be necessary to either fix the problem or shut it down.

In the early 2000s, Ford was struggling with declining sales and profits, and one of its losing operations was its luxury brand, Lincoln. To turn things around, Ford invested heavily in revitalising the Lincoln brand, focusing on creating high-quality luxury vehicles with cutting-edge technology and features. They also revamped their marketing and advertising campaigns to appeal to a younger, more tech-savvy audience.

As a result of these efforts, Lincoln's sales began to pick up, and the brand started to gain traction in the highly competitive luxury car market. In 2020, Lincoln reported its best sales in over a decade, with total sales up 3.4% compared to the previous year.

What Is the price/earnings ratio (P/E ratio)?

When it comes to understanding a company's earnings, one key financial ratio to consider is the price/earnings ratio, also known as the P/E ratio. This ratio represents the number of years it would take for a company to earn back the amount of your initial investment, assuming its earnings remain constant. In other words, it shows how much investors are willing to pay for each dollar of earnings.

The P/E ratio is also an indicator of investor confidence in a company's future earnings potential. For instance, a company with a high P/E ratio of 40 suggests investors are willing to take significant risks on the company's future growth prospects, while a low P/E ratio of 3 indicates that investors are sceptical about the company's future performance.

Price/ Earnings Ratio Formula | The Globetrotting Investor | Stock Analysis

Investing in rapidly growing companies vs slow-growing companies

Investing in a rapidly growing company means betting on its ability to increase earnings in the future. This is because high-growth companies tend to have higher P/E ratios than slow-growing companies.

A high P/E ratio indicates that investors are willing to pay a premium for the company's future earnings potential. However, this also means that the company needs to deliver incredible earnings growth to justify the high stock price.

In contrast, slow-growing companies tend to have lower P/E ratios because their earnings growth is more predictable and less risky.

Market context matters

When evaluating a company's P/E ratio, it is important to consider the broader market context. The stock market as a whole has its collective P/E ratio, which can indicate whether the market is overvalued or undervalued. Additionally, interest rates play a significant role in determining prevailing P/E ratios since low-interest rates make stocks more attractive to investors compared to bonds.

However, during bull markets, investors are generally optimistic about the future of the economy and the stock market. This optimism can drive up stock prices, as investors buy shares in the hopes of profiting from future growth. As the demand for stocks increases, the price of those stocks can rise to levels that are not sustainable in the long term.

This same optimism can also drive up the P/E ratio of stocks. Investors are willing to pay more for each dollar of earnings because they believe that the company will continue to grow and generate more profits in the future. This can lead to P/E ratios that are significantly higher than historical averages or even the company's historical P/E ratio.

However, when P/E ratios reach unsustainable levels, it is typically a sign that the stock market is overvalued and due for a correction. This means that stock prices could drop sharply as investors adjust their expectations for future earnings growth. The correction could be triggered by a variety of factors, such as a sudden change in interest rates or a geopolitical event that impacts the global economy.

Investors should be cautious about investing in companies with very high P/E ratios, as these companies may not be able to sustain their earnings growth over the long term. It is important to look at a company's historical earnings growth rate and compare it to its current P/E ratio. Additionally, investors should consider the broader market context and economic conditions when evaluating the sustainability of a company's P/E ratio.

Peter Lynch Quotes | The Globetrotting Investor | Stock Analysis

Bottom line

Earnings are one of the most important factors investors should consider when investing in the stock market. When a company is profitable, it can use its earnings to reinvest in the business, pay dividends to shareholders, or buy back stock. Investors should look for ways a company can increase its earnings such as reducing costs, raising prices, expanding into new markets, selling more products in existing markets, and revitalising or closing a losing operation. Understanding a company's earnings is essential, and the price/earnings ratio is a key financial ratio to consider. Investing in a rapidly growing company means betting on its ability to increase earnings in the future while investing in slow-growing companies tends to have lower P/E ratios because their earnings growth is slow. One should also consider the broader market context when evaluating a company's P/E ratio.


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