Profit isn’t opinion, Cash is a fact.
As a takeover platform, we often get asked the question, ‘how much is my webshop worth?’.
Unfortunately, this is a rather more complicated question because the basic rule of ‘x times the annual profit’ will not provide us a satisfying answer and the outcome is often a sensitive matter which leads to discussion. With this article, we hope to create some structure to the subject of ‘webshop valuation’ for both our webshop buyers and sellers. Even if you now don’t think about selling or buying, this article can provide useful insights to focus on valuation in the short term and to realise a higher sales price in the long term.
Valuation is a matter of opinion
Let us start with what exactly ‘valuation’ entails. According to economist Jan Vis, the definition of (economic) valuation is the amount that we ascribe to a company by adjusting the expected future income in terms of time and risk. Therefore, valuation is not a concrete or objective concept. After all, the valuation is determined based on estimates and therefore subjective. In other words: Valuation ‘is a matter of opinion’.
This might be a disappointment, but remember a buyer and a seller must always ascribe a different valuation (their ‘opinion’) to a webshop in order to reach an agreement. After all, both want to make a profit. So, valuation is almost never the same as price.
Discounted Cash Flow
What method should you use to determine the valuation of a webshop in the most objective way? Well, there are different options. You can take the intrinsic value or the profitability value. because the takeover market also has many basic rules (‘multiples’), for example, x time the annual profit.
However, these methods only look at the past, while the buyer must recoup his investment with future income! In other words: You must look ahead for the economic valuation. The Discounted Cash flow (DCF) method is the most used method to determine valuation this way. As the name suggests, the future cash flow is discounted by setting these off against the costs that must be made to realise this cash flow. The vision behind the DCF method is that ‘future money’ is worth less than current money. For example, do you prefer to receive 100 pounds now or in 1 year? How much future money has depreciated depends on the risk factors.
There are 3 important elements to determine the valuation of the DCF method:
In the following formula they are simplified, reflected in the free cash flow (money) and the required return (risk & time):
The quality of the result depends on the quality of the input, so you should always use sold business cases with well-founded forecasts and analyses.
Determining the valuation of a webshop
Variable 1: The free cash flow
The free cash flow is the money that can be withdrawn from the webshop every year without jeopardising the capacity to generate profit. This ‘free cash flow’ is calculated by correcting the operating profit (EBIT) before taxes, interest, depreciation, mutations in provisions/operating capital and (dis)investments. This sounds rather complicated, but it is a lot easier in practice because for many webshops these corrections are only applicable to a limited degree (for example, there is no stock to be depreciated).
Variable 2: The costs of the invested capital (‘requirement for return’)
The requirement for return determines what return is required to cover the risks. As there is a specific ‘premium’ for most business sectors, we use our own premium for webshops. For each webshop, we correct this webshop premium for the strengths and weaknesses of this company:
- Degree of dependence on suppliers
- Composition of the visitor flows
- Presence of entry barriers
We use a planning period of 3 years and limit the remaining period to 2 years because webshop(s) owners face many developments in a changing market.
Suppose they ask me to value 2 webshops with the same free cash flow of £10,000 per year. One operates based on drop shipping and was established less than one year ago and depends for 90% on Adwords. The other one has its own product line, has been in business for 8 years, and mainly receives organic traffic.
The required return of the first shop could come to 40% and of the second shop to 20%. According to the DCF calculation, the second shop is then almost worth double (£30,000) compared to the first shop (£16,000).
Webshop owners do not correct the free cash flow in their forecasts for their own hours and that is indeed the intention — the invested time is necessary to achieve the cash flow, and must, therefore, be included. The Discounted Cash flow follows a clear reasoning to a valuation. So use valuation to create a substantive discussion about the pricing. If not, negotiations will quickly turn into ‘bargaining’, which isn’t the right way to achieve a takeover of a webshop that you have put everything but your heart and soul into.