Image editing software company Canva recently raised another round of financing that valued the company at $40 billion dollars. 40 billion is a lot of dollars, so what does that mean exactly. How are companies valued, and what does that mean for investors? An everyday investor doesn’t need to know all of the details of company valuation in order to be successful. Still, it makes sense to have a basic understanding of how companies are valued.
What is Company Valuation?
A company’s valuation is a measure of how much the total company was worth. There are many different ways to value a company. This includes historical earnings, future earnings potential, or the sum of its assets minus any liabilities.
Historically, it was common for a company’s stock price to be a multiple of their net annual earnings. If General Motors earned $3 billion in a year and had 600 million shares of stock, they would have annual earnings per share (EPS) of $5.00. In current times, it is less common for stocks to be only valued based on historical earnings. This is especially true for startups that may actually not be profitable at all. Instead, they are valued based on their potential for future earnings.
How Are Public Companies Valued?
Determining the total value of a publicly traded company is a fairly simple calculation and possible given publicly available information. To calculate the valuation of a public company, take its stock price multiplied by the total number of shares of stock in the company. This is also known as its market capitalization or market cap for short.
Returning to our historical (and fictional) example of General Motors from the previous section. In our example, there were 600 million shares of stock trading at a price of $60 to $75. This would give our fictional General Motors company a market cap of 36 to 45 billion dollars.
You might also hear about “large-cap” or “small-cap” stocks. These determinations are based on the stock or company’s total market capitalization. Large cap stocks are typically those that have a market capitalization of 10 billion dollars or higher. Small cap stocks are those with market caps of about $300 million to $2 billion. Mid cap stocks are companies with market capitalizations that are in between.
How Are Private Companies Valued?
There are some similarities with how private and public companies are valued. The difference is that privately-held companies do not have to publicly disclose how many shares of stock that they have. In fact, private companies don’t even have to issue shares of stock (though most do). Additionally, unlike public companies, the shares of stock of private companies are not traded openly, so their value is not determined by the market.
Despite this major difference, a private company is typically valued in much the same way that a public company is. You just don’t know how many shares of stock a private company has. So when the news reports that Canva raised $200 million in new funding at a $40 billion valuation, it might be that the investors got 100 million shares of stock at a price of $2 per share or 20 million shares of stock at $10 per share, or anywhere in between.
Whatever the price per share that these investors paid for their shares of Canva stock, when you multiply that by the total number of outstanding shares issued by the company, it equals $40 billion. Since Canva is a private company, we don’t know exactly how many total shares there are, but for most people it doesn’t really matter. The average investor can’t buy shares in Canva (or any private company), so the stock price is whatever Canva and their investors say it is.
The Bottom Line — What Does Company Valuation Mean for Investors?
So you might be wondering, what does all this mean for me as a casual investor? The good news is that for most investors, a company’s valuation is not something you have to spend a lot of time worrying about. It’s good to know a little bit about it so that you’re familiar with the concept, but there are other concepts that are more important, like compound interest or sticking to a budget.
This is especially if you’re a beginner investor just starting out, you can just invest in index funds as a great way to start your investing career. As you get more experience and want to start investing in individual stocks, you can use a company’s valuation as a tool to help you decide if a given stock is a good investment. Look for companies whose valuation you think is lower than it should be — those can make for good investments.
Dan Miller is a freelance writer and founder of PointsWithACrew.com, a site that helps families to travel for free / cheap. His home base is in Cincinnati, but he tries to travel the world as much as possible with his wife and 6 kids.