Why Seemingly Similar Companies Have Different Valuations?

Furthermore, a company that possesses valuable inherent qualities such as strong branding, innovation, product development capabilities, and a high-quality management team typically indicates more sustainable cash flow, thus commanding a higher valuation than a company whose profitability is heavily influenced by external factors such as fluctuating commodities prices, clients with strong bargaining power, and homogeneous competitions. The presence of these inherent qualities enhances the stability and predictability of cash flow, thereby contributing to a higher valuation for the company. In short, the “endogenous” factors boosting cash flow are more valuable than the “exogenous” factors in most valuation cases.

For instance, consider two restaurants that are experiencing significant growth and have same return on equity (ROE). The first restaurant’s profitability is primarily attributed to its advantageous geographical location, while the second restaurant’s profitability stems from its inventive and unique dishes. Despite both restaurants having similar levels of profitability, the second restaurant might receive a higher valuation. This can be attributed to the facts that product innovation possesses inherent barriers and the replicability of those innovation and incentives to new stores opening, making it a distinguishing factor that adds value to the business.

Also, the valuation of two companies with comparable free cash flows can differ if there are variations in the levels of non-operating assets and liabilities or debt, which need to be adjusted when calculating equity value.