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I wonder if one day people would realise valuation on startups (after 5 years) should be based on profits…?

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How is the valuation on startups calculated?How long should startup be a startup? These days, it seems that some startups could be a startup like forever…? Much longer than 5 years for many of them.

Everyday, I read about how this startup or that startup getting a new high in their company valuation when another new investor invested into the company. Then, when I read a little deeper, I realised that these startups are either still losing money (but they have lots of potential) or they have very little profit if any (but they have lots of potential) and this was why they were valued at sky high prices especially versus their senior peers in the industry which are profitable but are no longer startups and the growth is already stable.

valuation on startups
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Let’s go back to the fundamental of a company share price valuation as per investopedia.com

What Is Price-to-Earnings Ratio – P/E Ratio?

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.

P/E ratios are used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.

As for what is Earnings? The below would be the definition by investopedia.com

What Are Earnings?

Earnings typically refer to after-tax net income, sometimes known as the bottom line or a company’s profits. Earnings are the main determinant of a company’s share price, because earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the long run. Earnings are perhaps the single most important and most studied number in a company’s financial statements. It shows profitability compared to analyst estimates, the company’s own historical performance, and relative to its competitors and industry peers.

If you like to read more, click here yeah. www.investopedia.com

How are listed companies which are NOT considered a startup valued?

They are valued as per the ratio stated above yeah. If they have good profit upward trend, their share price moves upwards to reflect the next year’s potential result. Their share prices would start showing a downtrend when it is clear that their profit numbers are on the way down due to latest circumstances. This is to reflect a fairer valuation of their share price.

To understand, just look at the share price for banks… versus those of glove manufacturers. For companies which are under the Fast Moving Consumer Goods (FMCG), it follows the trend but is usually on a more stable movement. Basic idea is a simple one, if the company is profitable, they either provide dividends which are much higher than the typical fixed deposit rates or the share prices move upwards which gives a capital gain for the shareholders if they sell the units they own.

If investments are no longer based on fundamental reasons

Everyone investing into startups would want the prices to keep moving upwards. Many of these startups share price is already running far ahead of their actual fundamental. It’s like a belief that this startup will definitely be extremely profitable in the future. Everyone buys into this ‘dream.’ Let’s always remember that there has been many occasions for stock market bubble bursting… property market bubble bursting and all these were because these markets were no longer supported by any fundamental.

Everyone was speculating and hoping that what they paid for today, someone will pay ever higher in the near future. The unluckiest would be the one who bought the “investment” at the highest price.

Money supply continues to increase, people look for higher returns

A low interest regime meant that many would be moving their money in the bank to other investments elsewhere to try and obtain higher returns. I do not think anyone could control how people invest their money but I still hope everyone would understand that a typical investment and their returns should be based on fundamental and not on hopes and dreams. I fully agree that startups with a good fundamental deserves a higher valuation than all the rest. What is alarming is that these ‘higher’ valuation may be taller than the Mount Everest…

Happy understanding and happy investing. What is investing? Earlier article here: Investing is like watching the grass grow

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