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Evaluation Methods of a Website. Part 2.
by Alexander O. (www.webskyguide.com)
Glossary:
EBIT (earnings before interest and taxes)
EBITDA (earnings before interest, taxes, depreciation and amortization)
EBIDRAD (earnings before interest, taxes, research and development, and depreciation and amortization
NCF (net cash flow to invested capital)
WASS (weighted average cost of capital)
DR (discount rate)
Specific features of developing IT companies.
Specific features of companies at their first stage of development are characteristic and similar for almost all of the companies. As a rule, there is a short history
of development, low profits, and lack of "operating" revenue. New IT companies, in most cases, are at the stage of development of new products, which are experimental
or totally unknown to the clients. These companies are similar in having regulation barriers: low capital, few tangible assets, and low creditability.
The main asset is technology and people. Everything that was said below is also true for Internet companies. Although the Internet created huge markets and distribution
channels, a few companies in this segment were able to keep the high price, despite the fact that all of them have experienced the difficulties of the formation period.
The market has doubted the economic models of IT Internet companies. Therefore, it makes this issue being of current importance.
Accurate tracing and the choice of price forming method lead to good management that results in creating and increasing the price of an Internet company. Management
starts from a competitive analysis as key parameters of evaluating web-businesses is absolutely equal to those of any other business: net cash flow and risk. Besides,
Internet companies' managers focus on regional parameters: sales value to one client, number of visits, and each dollar paid for Internet advertisement. Young companies
should start the analysis from studying the environment and the sector and finish with an internal analysis and the answer to the question: "How can the technology lead
to products, services, markets, clients and, in the end, to cash flow?"
Methods of Evaluation.
Evaluation should become an integral part of strategic planning in an Internet company. This is the axiom of success. Let us focus on the main methods of evaluation.
To evaluate a network business, profitable and marketing approaches, and sometimes variations of traditional methods are typically used. The Capitalization method and
multipliers price/earnings (P/E) are seldom used in the evaluation of Internet companies. Evaluating developing businesses on the basis of multipliers, which the market
set for Amazon or Yahoo!, means assigning a developing business size, growth, and customer data base of most successful Internet companies.
A more reasonable and suitable evaluation method for Internet companies is the discounting method (MPDM) that include forecasts of changing the company profit in the
process of development.
Reconciliation of historical data and the forecast is prepared by the analytical department of the company. Top managers or leading directors bear responsibility for
the final edition and accuracy. Lack of experience in evaluating IT companies prompted development and usage of some specific parameters. The basic ones are: earnings
parameter and profit multiplier before tax, interest, R & D and amortization (EBITRAD).
In addition, some other industrial parameters can be used. For example, the parameter showing the number of subscribers, number of visits, regular clients, visitors of
forums and chatrooms of an Internet company.
Let us analyze an invented IT company in the Internet services industry during one conditional year. Company bizenes.com, as we called it, provides services related to
web-design, hosting, and access to the Internet. The company is planning to become a leader in its segment within 2-3 years, to have the status of a public corporation,
and to increase profits from negative to positive. The management of bizenes.com is sure that it is necessary to evaluate the company. Below, there is a reconciliation
of key historical data and the forecast prepared by the management of the company.
Bizenes.com reconciliation of historical data and the forecast ($ millions)
example 1-1 |
| . |
. |
Historical |
Forecast |
| . |
. |
1 year |
2 year |
3 year |
4 year |
5 year |
6 year |
7 year |
| 1 |
Earnings |
1.12 |
3.28 |
8.44 |
13.69 |
17.22 |
31.76 |
52.53 |
| 2 |
Minus: expenses for the main
activity |
-3.05 |
-3.52 |
-4.8 |
-6.81 |
-9.9 |
-15.15 |
-19.37 |
| 3 |
Equals: EBITRAD |
-1.93 |
-0.24 |
3.64 |
6.88 |
7.32 |
16.61 |
33.16 |
| 4 |
Minus: expenses for R & D |
-3.65 |
-3 |
-8.81 |
-12.62 |
-9.12 |
-7.34 |
-10.75 |
| 5 |
Equals: EBITDA |
-5.58 |
-3.24 |
-5.17 |
-5.74 |
-1.80 |
9.27 |
22.41 |
| 6 |
Minus: depreciation and amortization |
-0.1 |
-0.14 |
-0.25 |
-0.33 |
-0.42 |
-0.54 |
-0.64 |
| 7 |
Equals: EBIT |
-5.68 |
-3.38 |
-5.42 |
-6.07 |
-2.22 |
8.73 |
21.77 |
| 8 |
Minus: expenses for payment of interest |
-2.18 |
-0.13 |
-0.24 |
-0.3 |
-0.39 |
-0.43 |
-0.43 |
| 9 |
Equals: profit before taxes |
-7.86 |
-3.51 |
-5.66 |
-6.37 |
-2.61 |
8.30 |
21.34 |
| 10 |
Minus: taxes |
0 |
0 |
0 |
0 |
0 |
-0.17 |
-4.7 |
| 11 |
Equals: net profit |
-7.86 |
-3.51 |
-5.66 |
-6.37 |
-2.61 |
8.13 |
16.64 |
In this situation, after studying the forecast parameters of the company development, the only financial indicator we can use is the profit multiplier.
To do that, we conditionally compare six analogous public companies. The chosen multiplier, earnings in this case, is applied to the profit of the company
under review to compute one value. Median is used more often. Example 1-2.
Bizenes.com, analysis of the market approach
example 1-2 |
| Parameters of analogous public companies |
| . |
earnings
(millions dollars) |
Price to earnings |
Price to profit |
MVIC/EBITA |
MVIC/EBITRAD |
| Company À |
35.2 |
15.5 |
ns |
ns |
27.4 |
| Company  |
24.5 |
12.5 |
17.1 |
15.2 |
14.5 |
| Company Ñ |
4.8 |
8.7 |
45.3 |
20.9 |
16.3 |
| Company D |
39.8 |
10.7 |
35.3 |
19.3 |
15.4 |
| Company Å |
24.1 |
7.3 |
ns |
ns |
10.1 |
| Company F |
10.4 |
9.3 |
ns |
ns |
11.2 |
| Median |
. |
10 |
35 |
19.3 |
15 |
| ns - no sense |
Analysis of the forecast.
Bizenes.com is planning to bear an operational loss during the first four years. In the second year of the forecast period, the company is planning to achieve a
positive EBITRAD value. The analogous companies have achieved positive EBITRAD values with a median value of 15. When using future multipliers of earnings or EBITRAD,
do not forget to take into consideration any investments necessary for generating future profit and revenue. In our calculations, we use the forecast value to compute
present value. It is necessary to discount the value of future multipliers. In the future, it will be necessary to consider forecast values of lack of money and the
discount rate.
Values computed with the help of the discount method are less flexible in comparison with the market multipliers. To compute the present value with this method it is
necessary to discount future cash flow using traditional two or three-step models. In two-step models, the value is calculated based on the amounts of present values
of forecast profit. In three-step models, there is an intermediate step as a developing company is unlikely to achieve stable growth in the post forecast period.
Therefore, we calculate intermediate growth for the required number of years. After that, we calculate remaining value.
As can be seen from example 1-1, the management of bizenes.com supposes that the company will have significant growth within six years (2-7 years). Then the profit
growth will remain at the 15% level for the following four years. The margin will remain at the 7th year level. The forecast has a condition that after the 10th year,
due to the formation of the sector and the general economic cycle, the growth will become stable and will exceed inflation. Thus, the discount model is realized. We
use a 30% discount rate based on summing the marketing and internal risks of the company. In the result of using MPDM method, the capital value of bizenes.com is equal
to 10.7 million dollars. Example 1-3.
Of course, net cash flow to investments is the most preferable of the discount models. But it is more suitable for traditional companies, which generate profit in capital investments and capital flow.
IT Internet companies are usually not profitable at their developing stage. This finds its reflection in taking money from the capital flow. For example, a significant part of the phenomenal growth of Amazom.com took place due to advanced payments by the buyers.
Bizenes.com, discount analysis (millions of dollars)
example 1-3 |
| . |
. |
Forecast |
| . |
. |
2 year |
3 year |
4 year |
5 year |
6 year |
7 year |
| 1 |
Net profit, data from
example 1-1 |
-3.51 |
-5.66 |
-6.37 |
-2.61 |
8.13 |
16.64 |
| 2 |
Plus: depreciation and amortization |
0.14 |
0.25 |
0.33 |
0.42 |
0.54 |
0.64 |
| 3 |
Equals: gross cash flow |
-3.37 |
-5.41 |
-6.04 |
-2.19 |
8.67 |
17.28 |
| 4 |
Minus: investments |
-0.9 |
-0.79 |
-1 |
-0.85 |
-1.8 |
-0.6 |
| 5 |
Minus: increase of capital flow |
-0.8 |
-1.26 |
-1.26 |
-1.28 |
-3.42 |
-4.62 |
| 6 |
Minus: payments of debts |
-0.13 |
-0.39 |
-0.66 |
-0.93 |
-1.33 |
-1.56 |
| 7 |
Plus: new debts |
0.9 |
0.79 |
1 |
0.85 |
1.8 |
0.6 |
| 8 |
Equals: net cash flow to capital |
-4.3 |
-7.06 |
-7.96 |
-4.4 |
3.92 |
11.1 |
| 9 |
Multiplied by the discount rate |
0.8771 |
0.6747 |
0.519 |
0.3992 |
0.3071 |
0.2362 |
| 10 |
Present cash flow cost |
-3.77153 |
-4.763382 |
-4.13124 |
-1.75648 |
1.203832 |
2.62182 |
| 11 |
Present forecast cash flow cost |
-10.59698 |
| 12 |
Present intermediate cash flow cost during the next 4 years (forecast) |
7.79 |
| 13 |
Present cost of remaining period |
13.49 |
| 14 |
Computed fair market value of capital (approximate, rounded) |
10.68302 |
Summary
Accurate forecasting allows for the evaluation of a more accurate fair market value for an Internet company. The most important factors in the forecast are volumes,
prices, margin, and reinvestment of the capital in order to achieve the forecasted profit for the company. Strategic analysis made based on the competitiveness of the
company should give an idea of and basis for pricing policy and of the margin value. The key to this is an awareness or vision of the future, not the past. The history
of losses and weak present results should never influence the future prospective. A unique characteristic of Internet companies is a short life cycle for products and
constant global technological changes. A key to creating (increasing) the value of IT companies is in constant possibility of achieving competitive advantages. Thus,
the forecast should reflect the strategic plan of the company and connected with it the competitive analysis. It should reflect efforts and skills used to overcome
uncertainties as they appearance.
We used these materials to prepare this publication:
Frank C.Evans, David M.Bishop "Building Value in Private Companies"
Patrick A.Gaughan "Mergers, acquisitions, and corporate restructurings"
Chris M.Mellen www.delphivaluation.com.
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