- December 1, 2016
- by Sam Graves
- 10 minute read
The old saying goes that something is worth whatever someone is willing to pay for it. Still, buyers don’t want to pay more than they have to, and sellers don’t want to get less. Certain objective criteria can determine the fair value of an e-commerce business that buyers and sellers can agree on, or at least serve as the basis for negotiation
The key term here is “fair.” To derive a fair e-commerce business valuation requires employing the proper valuation methodologies and gathering information relevant to the overall valuation analysis.
Here, we’d like to give you a sense of how an e-commerce business can be objectively evaluated, not necessarily provide a how-to on valuation. However, familiarising yourself with the basic concepts better prepares you for discussions about what an e-commerce business is really worth, and arriving at a realistic market valuation.
Proper Valutation Methodologies
Multiple of Seller Discretionary Earnings
Most valuations of an e-commerce business look at the historical earnings—the net profit of the business for at least the last twelve months—and apply a multiplier (typically between 1.5 and 3.5, though some calculations put the multiplier as high as 5) to arrive at the company’s valuation.
Let’s quickly look at this in action. Let’s assume there is an e-commerce business that has made £100,000 net profit in the last 12 months and has been given a multiple of 2.75x based on many factors. With this information, we can calculate the value of the business, which would come out to be worth £275,000. This gives an example of how a multiple is used to reach the valuation for the business.
How that multiplier is determined depends on a number of factors that the brokers, buyers and sellers agree are relevant. Some of the most important factors are revenue growth, consistency, scalability and the amount of work required to operate the business. Basically, and somewhat simplistically, the more favourable factors presented, the higher the multiplier and, hence, the higher the valuation.
Discounted Cash Flow Analysis
Another method used to value a business is discounted cash flow (DCF) analysis. Essentially this is an estimate of future return on investment, adjusted for the time value of money (i.e., £100 received today is worth more than £100 a year from now because today’s £100 invested at, say, a 10 percent rate is worth £110 a year from now). Basically, DCF calculates the last year’s free cash flow (FCF) by subtracting capital expenditures from the period’s operating cash flow. It then projects a cash flow growth rate over the five years and discounts it according to the weighted average cost of capital (WACC) of the business.
For an established traditional business with a history of stability, DCF provides a reasonable valuation. Due to the wide variance in monthly cash flow typical of e-commerce ventures and the volatile nature of e-commerce markets in general, DCF is not well-suited as the primary method to value an e-commerce business. That said, however, it is a “nice-to-have” analysis. The DCF could, for example, show a significantly improved FCF in the current year over last year, prompting an investigation into its cause and likelihood of continuing. Is it because sales have increased, costs reduced, both, or some other factors? All things that are good to know.
While also not a primary valuation method, the acquisition price of similar companies in similar markets can provide some useful points of reference. This can be tricky, however, as the valuation criteria even for similar businesses may be different and not relevant to a particular situation. It is therefore important to identify the metrics used for the transaction to come up with an accurate comparison. Even then, this is more of a “reality-check” than what ultimately determines an e-commerce company’s valuation.
Traffic is the heart of any e-commerce businesses. Without traffic, an e-commerce business would be worthless because you wouldn’t be able to make any sales. For that exact reason, traffic plays a key role in the valuation process. Not all traffic is created equal and some will be of higher quality than others. For example, a store might get 500 visitors from a viral Facebook post, but if that doesn’t lead to any sales the traffic was all for nothing. For this reason, traffic stats can sometimes be misleading in the valuation process and requires sufficient research to determine the quality of the traffic. More traffic isn’t always better and often times it’s the case of quality over quantity.
One of the best ways to determine the quality of the traffic is to use a measurement called revenue per user (RPU). This metric shows how much each visitor is worth to a business. This is the perfect stat to look at when finding what traffic channels perform the best. For example, if Google organic traffic has a RPU of £.50 and Pinterest has a RPU of £.03 it’s easy to tell which traffic source is better and of higher quality.
Another thing to keep in mind when looking at traffic stats is the concentration. This will look at how diversified the traffic sources are. Is 90% of the traffic coming from organic search? Or are there many different sources that bring in a small chunk of traffic?
It’s common for e-commerce businesses to have one traffic source that drives the bulk of the traffic, but the more diversified the traffic sources are the more attractive it will be to potential buyers.
Also keep in mind that organic generated traffic (i.e., no CPC marketing costs) is not necessarily a better value than a website that pays to generate traffic. This seems counterintuitive. However, Google continually changes its search ranking algorithm and traffic patterns can dramatically shift from one month to a next. There’s more certainty in knowing that paying for traffic gets predictable results than depending on SEO strategies that rely to some extent on guesswork that may not be replicable to future situations.
When it comes to traffic the higher quality and more diversified it is, the higher the entire e-commerce business will be valued.
Financials and Operations
E-commerce is a business like any other, so of course you want to know the usual financials such as gross revenues and net income, profitability, costs of inventory and operating expenses, among other standard measurements. Other operational factors to consider include:
- Product concentration - To what degree do revenues depend on certain products? Are there too many products that account for insignificant percentages of total revenues?
- Underlying cost structure - Can this be easily transferred to new ownership and replicated? What areas can be improved or eliminated?
- Supplier Agreements – Are the current suppliers willing to stay on board with the new owner? Are there any special agreements or deals in place with the supplier? If so, will this be continued with the new owner?
- Scalability - Can current operations ramp up and expand under new ownership without incurring prohibitive costs? Is there room to expand into new products?
- Assets - Is there physical property that has value to new ownership? Can unwanted assets be liquidated or otherwise disposed of easily? What is the book value of the business if everything was sold?
- Payroll - Are current staffing levels sufficient, how are they managed, are salaries competitive to retain essential talent, and will talent likely stay if ownership changes?
- Trademarks and Licenses - Are there any proprietary products or processes that provide unique competitive advantage?
- Liabilities - What debts does the company have, what is its credit history, has the company every had difficulty meeting its debt obligations?
- Future commitment - What is the minimum time and expense that a potential owner must be willing to commit to run the business?
- Customer Base/Market Niche
An active customer base will increase the value of any e-commerce business. An active customer base is one that has repeat customers and people that keep coming back to make purchases. This is a sign of a business that produces great products and has built solid relationships with their customers.
On the other hand, an e-commerce business that sells to a customer once and then never hears from them again is not going to be valued as highly.
Here are some other factors to consider:
- How does the e-commerce business acquire customers, and what are the costs of customer acquisition?
- How unique is the customer base and to what extent is it growing?
- Number of competitors for the particular market niche(s)
- Existence of an established mailing list
- Churn rate
An e-commerce site with an established and well-recognized brand identity is worth more than a business in the beginning stages of establishing a brand. Without a brand, the only differentiating factor among businesses that sell similar products is the price. When this happens it ends up being a race to the bottom, which isn’t good for any of the parties involved.
A loyal customer base assures continued revenues; established brands also have greater likelihood of attracting new customers, especially in saturated markets such as fitness or mobile apps.
The relative strength of a brand can be assessed in numerous ways. These include Google search rankings by company name and products/services, quality and quantity of customer reviews, social media forums concerned with relevant product offerings and general discussions related to the e-commerce company’s particular markets. Most importantly, a good brand will be the factor that makes the customer choose your product over your competitors.
This could be the factor that could make or break a deal for any e-commerce valuation. To what extent can the website business continue to operate successfully without the current owner at the helm, either because of the owner’s technical knowledge, relationships with customers and employees, and/or reputation in the industry? Owners can mitigate this concern by removing themselves from day-to-day operations prior to putting their e-commerce business up for sale. The easier it is for someone to take over ownership and successfully run the business, the more attractive it will be.
The easiest way to make the ownership transition as seamless as possible is to start creating standard operating procedures (SOPs) for every aspect of the businesses operations. By doing so, it will make the new owner’s life a lot easier once they take over ownership of the business.
If removing oneself completely from the business is not possible, and it seems that owner involvement may be necessary for the success of any transition, potential buyers must consider:
- Willingness of owner to participate in a transition period, and for how long
- Expense of keeping owner as an employee or consultant
- Precise role the owner will take
- Likely potential that previous owner can work successfully with new ownership.
Look at the Big Picture Even a brief overview such as this indicates the multiple considerations that must be completed to get an accurate look at the true value of an e-commerce business. When looking at specific variables, always put them in the context of the larger picture. Certain factors are going to weigh differently than others depending upon the potential buyer’s objectives to acquire the business, marketplace characteristics, current state of the economy and emerging trends specific to a given industry and e-commerce as a whole, among other considerations.
Successful buyers do their homework. Successful sellers have an approximate picture of what their businesses are worth, and are positioned to garner the best offers. In both cases, an experienced website broker is essential to satisfy all parties involved.
Sam is an e-commerce expert and brings her know-how to the We Make Websites blog on a regular basis. Focused on providing quality Shopify and e-commerce advice, some favourite topics include CRO, SEO and best practice content marketing techniques.