The Ultimate Web Site Valuation Guide

Principles of Business Valuation

“There seems to be some perverse human characteristic that likes to make easy things difficult.” —Warren Buffett

And perhaps no group of people likes to make things more difficult than accountants. It’s a commonly held opinion that they introduce a lot of complex-sounding terms to make themselves look clever and enhance their perceived value!

Here, we’ll walk through the terms you might meet in your site-valuation endeavors to demystify them and explain how they work. And if you’re keen to do any calculations for yourself, we’ve reduced it all to some very simple spreadsheets you can download. Whether you want a Discounted Cash Flow, Net Present Value, or a Balance Sheet, don’t miss these killer tools—all of which are free!

NOTE: Businesses and Web Businesses

Anyway, that’s enough of them. For the purposes of this article, we’ll deal solely with those sites that are being sold as businesses, not those that merely “have a lot of promise.” That said, here’s a useful link to a page devoted to converting your non-profit-making web site to a web business that buyers drool over.

Present Value of Future Earnings

Let’s roll our sleeves up and dive into valuation methods. It’s all well worth knowing—knowledge is power, after all—but if it really isn’t your cup of tea, just download the spreadsheets here and they’ll work the magic for you.

First, let’s have a look at some reliable business valuation facts:

• Valuation is a mix of objective and subjective tasks.
• It is very common for web site owners to value their sites far above real worth.
• The better the quality of the data (the earnings and traffic stats, for example), the better the quality of valuation.
• There are always external factors out of the control of the seller, such as interest rates, that affect the valuations buyers make.
• There is no one exact valuation for any business; value, like beauty, is in the eye of the beholder.

The reason average buyers invest money on a business is because they expect to reap some profit from it. They use some level of guesswork or skill to estimate future profit, and the amount of expected profit determines how much they are willing to pay now.

Let’s anticipate how these buyers might do this by unpacking this accounting problem. Here are two hypothetical businesses that are both selling for $10,000, and both will have the same residual value after four years.

• Fast Movers Ltd: FML is expected to generate $5,000 of profit in the first year after takeover, and no profit for the three years following.
• Slow Movers Ltd: SML is expected to make nothing in the first three years, but $5,000 in the fourth year.

If you encountered this scenario in the real world, you should immediately ask yourself why the two sites are being sold at the same price. Clearly FML’s new owner has the use of $5,000 (the first year’s profit) for three years, which is a perk that SML’s new owner won’t have. So either FML is priced too low, or SML is priced too high.

This exercise demonstrates that it’s not just the amount of expected profit, but its location in the future timeline that determines current value. The more heavily weighted towards the current point in time, the more valuable those future cash flows will be to the business buyers and the more they’ll be willing to pay to own them.

The calculation does become more complex, though. Consider FML’s and SML’s projected profits in a different situation:

It’s not so easy to immediately spot the better buy now, is it? That’s where a handy accounting trick comes into play; it’s called Present Value (PV).

Because there’s a time value to money, future cash flows can be discounted to a current value. To get $1,000 next year you may need an investment of $910 today. But to get back $1,000 a whole two years from now, it may take an investment of only $800 today. That $910 and $800 are PVs for the future return of $1,000 (in 12 and 24 months respectively).

In other words, for a given rate of interest it is possible to work out how much would be required today to generate $1,672 in the next 12 months. Since that’s the figure FML is going to generate in the first year, we have effectively reduced FML’s first year’s profit to a PV.

By applying that same PV calculation, it is possible to establish a sum required now in order to generate $3,845 in 24 months, or $6,427 in 36 months, and so on.

We can therefore calculate a PV to all FML’s expected future profit. Adding them up then gives us a total of today’s value for all those future profits. That’s what we expect to flow in.

What is flowing out, don’t forget, is the initial investment of $10K. Subtracting the initial investment from the Present Value gives us Net Present Value (NPV). It’s a figure we can compare against similar computations applied to SML’s projected profits. Consequently, the business with the higher NPV is the better buy.

Calculating Net Present Value

NPV can be derived using the following formula:

NPV = CF₀ + CF₁/(1+r) + CF₂/(1+r)² + CF₃/(1+r)³

(where CF₁, CF₂ are the cash flows in year 1, year 2 and so on; R is the discount rate (the “interest rate”)

That said, the FML–SML example provides a comparative situation that is very rarely the case in real life. Even so, the usefulness of the tool isn’t in any way compromised by the fact that the buyer is usually judging a business on its individual merits. Once the buyer has arrived at projected profit figures he or she is comfortable with, it’s a reasonably simple continuation to plug those figures into the formula to arrive at an NPV for that business’s future profits. The NPV goes up if a quantity of earnings is brought forward in time, and it goes down if earnings are postponed. Remember that all these earnings figures are projections, and reside in the buyer’s mind.

The other key input in NPV arithmetic is the interest rate. The higher the interest rate the buyer wants to apply, the lower the NPV and vice versa. That’s because the profits are being discounted by the interest rate; the higher the rate of discount, the lower the value arrived at.

NOTE: More on NPV

Discounted Cash Flow

In the calculation of NPV, the core inputs were the cash flows and the discount rate. The cash flows are a projection, but where does the Discounted Cash Flow (DCF) come from?

This discount rate is provided by the buyer and reflects the risk perceived in the investment. When buying a rock-solid, well-established, blue-chip company, a buyer may be willing to use a rate of 12% per annum, whereas 80% per annum might be required for an internet business perceived as particularly risky.

There is no right or wrong discount rate. Each buyer uses his or her own rate, and for a given web site, different buyers may use different rates to arrive at completely different figures for what that site is worth to them.

Internal Rate of Return

We’ve seen the outline of how Discounted Cash Flow (DCF) works to give us NPV. There is one other way of discounting future cash flows; it’s called the Internal Rate of Return (IRR). The IRR is the rate of return/interest rate at which the NPV equals zero.

The IRR is not the favored method of calculating value for several reasons—use an MIRR if you really have to. For one, it doesn’t suit some projects—think of government projects, where there is just cash outflow and no inflow. But we’ll cover it for reasons of thoroughness.

Remember the discount rate applied to the NPV calculations from earlier? It’s a pre-decided rate that is applied to the calculation. When that rate is plugged into the NPV formula, we end up with either a negative or positive NPV. Under IRR, this rate is left to adjust to whatever level it needs to reach to ensure that the NPV equals $0. The level it reaches is the Internal Rate of Return.

Of two competing investments, the one with the higher IRR is the better investment.

Fair Market Value

Web properties valued formally for accounting or legal purposes are usually valued at what’s called Fair Market Value (FMV). FMV is the price at which the property would sell at a hypothetical transaction between a buyer and seller who are aware of the facts and are both acting voluntarily.

Accountants can’t just put any value to a business’s assets. They are governed by a lot of rules on how they can value assets for purposes of use in the balance sheet, statements to a stock exchange, and so on. When you see a web site listed in a balance sheet, the figure quoted is likely to be the FMV as governed by international accounting rules that go into these matters in great and boring detail.

But while FMV is great for all these Balance Sheet reasons, it’s not what you’d really expect a site to achieve at a real sale. FMV does not take into account that:

• a buyer may make due-diligence findings that affect the price
• the projected earnings used in real sales situations could differ considerably from the historical earnings used for FMV calculations
• a seller’s proper positioning and clever marketing can push the price upwards
• sellers taking a longer view and deferring part of their payment contingent on the site’s continued success can get a higher price
• a synergistic buyer would pay a premium for the efficiencies he or she recognizes in the merger

Therefore, a valuation shown in a company’s books may bear no resemblance to the real value of a site. The Fair Market Value is not a fair market value.

Do the complex calculations, spreadsheets, specialist accounting programs, and a PhD in Merger & Acquisition accounting underpin every valuation? Hardly. Many buyers wouldn’t be able to tell a Discounted Cash Flow from a Dyspeptic Chicken Fajita. However, a formal understanding of the principles is not a prerequisite for the experienced buyer. This buyer may reach competitive value conclusions based on no more than gut feeling, but that’s instinct backed by an intuitive understanding of what the competition is likely to pay. In value terms, it adds up to the same difference.

If your eyes glaze over at all these computations, take this one thought away: in most cases, the expectation of future profit—and the quantity and timing of that profit—is the sole driver of valuation.