The Tenuous Link Between Profit and Company Valuation

A key restraint for businesses is the misguided belief that profits matter. They don’t.

While Wall Street has made the link between profit and valuation a de facto law of investing, there is nothing in today’s economy for which that makes sense. We don’t need a P/E-ratio to value a company. A company’s value is determined by what two parties agree it is worth when they make a trade. That is all. If I think the price will go up over my investment horizon, then I will buy the stock. If I want cash, I will sell the stock.

Silicon Valley knows that profit is only important to their friends on Wall Street. They comfortably invest in companies that not only have no profit but have no clear ideas how they will ever make a profit. This is the economy of today and the future. Profit does not mean good business. Good business is determined by analytics like growth rate, market share, MRR, CAC, and the like. The company needs to have a path to cash flow positive (or breakeven), but not to GAAP net profit. 

In the past, many large companies provided dividends to shareholders from their net profit. A few still do. But dividends are just one factor in determining a company’s valuation, and hardly the most important in today’s world. Even very profitable companies, like Apple and Google, do not provide dividends. Those companies have high valuations because they generate huge revenues, maintain significant market share, and continue to grow in large and expanding markets.

And, perhaps most importantly, those companies have high valuations because that is what the market of investors will bear to buy their stock. That is the single, direct basis for determining a company’s valuation: the price of the stock times the number of shares outstanding.

I realize this is an extremely simplified presentation of this concept, and thousands of brilliant economists have come before me and more thoroughly explained market dynamics and company valuation in far more complex terms. I also actually worked on company valuation when I was an analyst at Bank America Capital Corp. back in the early 90s and so I have a pretty good understanding of how “expert” valuation is done.

But there is nothing inherent about profit that makes it required to determine whether I should invest in a company or what is worth now or will be worth in the future. Nothing. 

What’s more, profit is easily manipulated by a company and can actually be quite detrimental to the long-term sustainable success of a business. I can make my profit higher over the short term through various cost-cutting methods or even accounting shenanigans. Either of these actions is a step down the path of death for a company: the death of its soul and then its corporeal state. 

Let’s not confuse this with making money. Making money is essential. Revenues are great. They reflect customer delight in your product or service. They allow you to invest in all kinds of beneficial things: people, equipment, your brand, etc.  Costs, of course, shouldn’t exceed revenues over the long term. But there is no benefit to reducing them just to increase net profit. The ideal is to end the fiscal year with zero profit—to be profitless.

What would be nice is if Wall Street also saw this as the goal, and rated companies based on the consistent and intelligent use of funds, rather than on how much cash they could stash in a tax haven. But, as I wrote elsewhere, this would require a fundamental shift in how business is viewed and a new type of profitless company, the Service Corporation.

Until then, my recommendation is to remain private or be like Jeff Bezos of Amazon and ignore Wall Street’s unsupported link between profits and valuation to build the business with an extremely long-term vision.