Business Valuation Formulas & How to Use Them

Fortunately for us and for you, the marketplace is in very strong agreement with how it values web-based businesses.  Although there is some variation with some specific industries, the vast majority of online businesses are valued using a multiplier of the owner’s annual profits.  The formula is simple.  It is:

your discretionary annual cashflow x some number = value

The first reaction most people have when they look at this formula is that it is overly simplistic.  What about the domain name? What about that #1 ranking in Google? How can you really place a value on that?

The mistake most people make when thinking about the value of their site is that they think of it in terms of a + b + c = total value.  In other words, they think the domain is worth $5,000, the Google ranking is worth $100,000, and the cashflow is worth $50,000.  The marketplace doesn’t view valuations in this way.  Rather, it looks at values in terms of a scale, not in terms of “sum of all the parts.”

Involved in the formula above is the determination of what the “some number” value is.  That “some number” makes a big difference in your eventual asking price.  Consider for a minute that your website generates $50,000 of owners discretionary cash flow per year.  If that “some number” is 4, then you could bring in $200,000 by selling your business.  If that “some number,” however, is 1.5, then you are only looking at $75,000.  That’s a swing of $125,000 just based on a simple multiplier. As we will see in this series, most of a proper valuation is spent on determining what multiplier should be applied to your business to determine its value.

About that Discretionary Cashflow

Before we get into determining the multiplier, it seems appropriate to define what “discretionary cashflow” means.  What we are looking for to arrive at this number is the total owner benefit over the course of one year of running your business.  Starting with your income statement, we take the net profits of your business (total revenues – all of your expenses), identify expenses that are not related to the business (you know, that “conference” that you went to last year and brought your entire family with?), add in any money you paid yourself, and come up with the number. (It is important to note that we only add back money you paid yourself that shows up as an expense. If you take distributions, these do not show up as an expense).  When we do an initial valuation we don’t worry too much about being terribly accurate on the cashflow, but a detailed valuation usually involves some investigation to make sure the number we come up with is correct and justifiable.

Many business owners lose money because they do not properly track their finances.  A lot of money can be left on the table for the business owner who is not able to properly identify and prove their true cashflow.

Determining the “Some Number”

So we know that there are two parts to a valuation formula – the cashflow and the multiplier.  The cashflow is something that can be determined through accounting.  There is not much art to determining the cashflow of a business.

Determining the multiplier, however, is where having experience in dealing with the marketplace comes in handy.  When a broker is looking to determine the value of your site, what they are really looking for is how your site compares to similar offerings currently for sale and how you compare to those similar offers.  It could be boiled down to something as simple as this: is your site better than average, or worse than average?

Now there is more involved in this than simply going on “gut feelings.”  There actually are key things that a good valuation expert is going to look for when determining your value.  Below is a list, albeit VERY incomplete, of items that are considered by most brokers (at least my brokers):

Transferability

• How easy will it be for a new owner to walk into this business from day 1 and make money?
• Does the current owner bring any traits or skills that cannot be replicated easily?
• Is the current owner too closely associated with the success of the business?
• Is the current owner’s location key to the success of the business?
• Are there any licensing requirements in order to run the business?
• If the current business has vendors, are there any requirements that may prevent a new owner from being able to run the business?
• Are there any outstanding debts that need to be considered before a new owner comes into the business?
• Is there a steep learning curve for the niche that the business is in?

Market

• Is this a terribly competitive industry?
• Is there are very low barrier to entry?
• Is this market growing or shrinking?
• What is the market cap for this niche?
• Does the market have a sufficient level of appeal to grow the business within the marketplace?
• How easy is it to branch off into complementing markets?
• Is this a mutually exclusive market? In other words, can one client be serviced by two or more companies?

Current Marketing

• Is the business relying on just one source of marketing? How stable is that source?
• Is the business spending a disproportionately high amount of money on marketing to turn a profit?
• If the site enjoys strong search engine rankings, how secure are those rankings?
• If the site enjoys strong search rankings, is it from short tail, long tail, or a mix?
• How active is the customer base? Are they re-ordering? If so, at what clip?
• How fertile is the customer base?  Is it possible to remarket to them?
• How old is the site and does the domain name offer significant benefits?

Finances

• Is the business growing, shrinking, or stable? For any of these, over what period has that trend been present?
• How old is the business?
• Are the finances clean, easily verifiable, and easy to understand?
• Are there any odd blips in the financial history of the business? If so, are they easily explainable?

Other

• Does the business offer any unique advantages? (exclusive product line, trademarks, etc.)
• Is the business limited by any self-constraints? (software, market, etc.)
• Is there any specific technical challenges to running the site?
• Is the business well planned out, or is it a “thin” business (this will need explaining at a later date)

As I mentioned, this is FAR from a complete list – it is simply what I have thought of in a quick “stream of consciousness.” Given more thought there would be more factors (possibly organized a bit better as well). However, it should give you a slight idea of the various things that we will be talking about in future posts on this topic.  Learning how to control the answers to these questions will give you a great opportunity to identify flips, identify what you can do with your business to increase its value, and learning what types of businesses to establish.

What About Other Valuation Formulas?

I had a conversation with a buyer who I have gotten to know quite well over the past year.  We were talking about using different valuation methods on a particular business.  Specifically, rather than valuing based on cash flow, we were talking about valuing based on membership levels and the relative benefit each member means to an acquiring business.  For example, if you have 100,000 members, and you know Company X wants those members, and you further know that Company X spends on average $5 per acquiring a member, it follows to reason that you have a value upwards of $500,000 for that membership base.  This method of valuation can produce drastically different results than the cash flow multiplier.

The fact is, there are many different valuation formulas that one can use.  People within the marketplace will often times have their own valuation formulas that are far more sophisticated than the one presented above.  They have specific items they are looking for and specific metrics they have identified as important to their goals.

The reason I am offering this formula as a good rule to judge by is that it is so simple and so generic.  The marketplace consists of hundreds, if not thousands, of buyers.  It is best to use a formula that is general to encompass the many needs, perceived wants, and requirements of the individuals in that marketplace.  It should never be assumed that when a valuation is done on a site, that this is the price you are going to get – people will normally offer less than you ask, and they normally will come up with that price in different ways than you imagined.

As with all things that you read on this site, keep in mind that selling a business and buying a business, while very much a science, is also partly an art and a skill that involves identifying the unique aspects, benefits, risks, and drawbacks of each individual business.

In the next few posts I’ll look at what factors you can most control to increase your value.