Pricing Websites: The Importance of the Discount Rate
When website valuation or pricing websites is discussed far too often the emphasis is on the "x month's revenue" metric. It is not surprising that this is the case given that the market for buying and selling websites is extremely immature and the standard business techniques have not found their way into it yet.
In most markets where transactions take place to exchange assets it is commonly understood that there is an expected return from the asset, or a certain amount of income that the asset will bring to it's new owner. The prices for these assets in established markets are typically derived by taking the expected returns and mathematically 'discounting' them back to a present value (the expected returns are in the future.)
Since the market for buying and selling websites is so immature, transaction participants typically engage in an elementary approach to establishing a website value, which bears little if any resemblance to the asset's actual value when considering risks and expected return. Often times this number, something like "15 month's revenue," is simply pulled out of thin air or based on some Internet marketing forum post. One of the many problems with this approach is there is no scientific method to assessing the risk and including a risk component in the price. By establishing a risk-adjusted expected return and discounting future cash flows by this return, there is some science behind the price establishment process from which deal negotiations can begin. This last statement is important since it is not the math that will determine the price, but ultimately what the buyer is willing to pay and at what point the seller is willing to unload.
The fact that there is a lack for this basic and widely understood business practice in the website marketplace is actually quite exciting if you view it from the standpoint of someone looking to take advantage of the situation!
For those of you not familiar, discounting is simply the opposite of compounding. You've heard of compound interest: $1.00 earning 10% for one year compounded annually is $1.10 in one year's time. After two years however it is not $1.20 but rather $1.21. The reason being that it was $1.10 that earned interest the second time around and not the original dollar.
Discounting, like I said earlier, is the same concept in reverse. If I have an asset that will be worth $1.21 in two years time and the buyer is looking for a 10% annual return on his investment, the buyer would be willing to pay me $1 today for that asset. Why might I sell it? Maybe I have another investment that is going to give me 15% on my dollar!
As far as risks go, lets look at two extremes: Internet Business investment vs. buying a treasury bond. Either way, you are investing your money. Obviously the risks for the Internet business are much greater therefore the discount rate to establish the price should be much larger! You may by the bond that will be redeemable for $10,000 in one year for $9,900 today. You can be darn sure you will be getting your $10,000 in a year (assume low risk govt. bond). However, if someone said I've got an Internet business that will bring in $10,000 over the next year, you certainly wouldn't pay $9,900 for it! The discount rate for that website purchase must be much larger!
There are specific methods for establishing a discount rate. It is done every day around the world by consultants, investment banks, and corporations looking to buy or sell assets. The market for buying and selling websites has not caught on yet but as the market matures is most definitely will.
By Mike Batta