One of the primary steps in valuing a website is to forecast its future cash flow streams. By cash flow I do not mean the revenue generated from affiliate programs or ad sales, nor do I mean accounting profits. What is meant by cash flow is the actual physical cash in the door at the end of each period. In this section we will first take a look at the basic components that make up the cash flow and how to consider forecasting them, then take a look at some unique cash flow situations to consider, and finally discuss the appropriate length of time into the future to forecast.

The easier part of the cash flow determination is the sales revenue. A basic model may say that given a steady level of work on the part of the publisher updating and adding to the site, the number of visitors and associated sales revenue will continue to increase over time at its historical rate. A more complex model will take into consideration dynamic information and formulate several potential revenue streams and then give each one a “weight” related to the probability of the component actually occurring. To have the best valuation model, the more complex method should always be used.

NOTE: the web valuation spreadsheet included with this book is programmed to do all of the below calculations for you.

Historical Growth: Geometric Mean vs. Average

Before taking a look at the future, we must first establish the historical growth rate. To establish the historical growth rate we will first calculate the growth rate of each year’s cash flows (or month if the site has limited history) and then calculate a geometric mean of those growth rates. Important: throughout the text I will use “periods” and whether you should use months or years will be determined by the amount of data available. We will discuss this briefly at the end of this section. OK, why a “geometric mean”? The geometric mean will normalize ups and downs in the period-to-period growth rates were the “arithmetic mean” (or “average”) will be tainted be these. Here is a quick example to explain this. We’ll take a 10 period growth rate in revenues and compare the arithmetic mean to the geometric mean of the growth rates. The table below lists the period (month or year), the cash flow amount for that period, the growth of cash flow over the previous period (expressed in decimals and formulated by current year-previous year divided by previous year) and then below is listed the geometric growth rate vs. the average growth rate. The geometric growth rate is calculated by taking the last year and dividing it by the first year and raising the result to 1/n power were n is number of periods minus one. We then do a “check-calc” to check and compare the results. To do this, add one to the average growth rate (it is already embedded in the geometric calculation), and multiply out by this growth rate starting with the first period cash flow. For example, if the average growth rate is .2 (or 20%) and the first period cash flow is 100 and there are three periods we would do 100 x 1.2 x 1.2 = 144. Note that the starting 100 is the first period so the growth rate only needs to be multiplied two more times to get to the three periods. We need to add the one to the rate because if the growth is .2 or 20%, we want to say “original amount plus twenty percent of the original amount” and not just “twenty percent of the original amount.” By adding one we achieve this since one multiplied by any number is that number.

As you can see, the geometric growth rate (1.2599 or about 26%) “checks back” to the ending cash flow amount were the average growth rate (1.2878 or about 28.8%), calculated by adding up all of the period-by-period growths and dividing by 9, overstates the historical growth.

Originally I mentioned how big swings in growth rate, and particularly negative growth periods mixed in the historical growth, can badly damage the average growth model. The below table does the same calculations but throws in one bad year in the middle causing a negative growth situation. Notice how badly this effects the outcome of the average growth rate were the geometric growth rate still checks back to the ending 4,000 period.

Terminal Value

The idea of a terminal value stems from the thought that a business cannot go on forever at increasing growth rates. At some point in time growth will level off or the business will be liquidated. Growth usually levels off as the business matures and there are less and less opportunities for new growth areas. At this point, the business growth may even decline. For this reason, along with administrative ease in performing valuation analysis, a terminal value must be assumed. The terminal value portion of a website valuation analysis could easily represent a large portion of the end result; so it is important to put a fair amount of consideration into establishing it properly. There is much subjectivity in the terminal value so several methods should be used and scenario analysis may be needed to look at the total valuation in the context of various terminal value situations.

Different Techniques for Determining Terminal Value There are several ways to determine a terminal value. The most common may be the perpetual growth model were the analyst assumes that the web property, at some point in the future, will refrain from the rapid growth stage and sustain a constant rate of growth into the future. The constant rate does not mean that the analyst believes the growth will literally be the same every year starting at some point in the future. Rather, the idea is assuming that over the long run, beginning at the end of the rapid growth stage, the rate of growth will average out around x%. For example, the owner of a website that is looking for additional investors or to sell the site is going through a valuation analysis. His view (often seen through rose colored glasses to capture the best price) is that the terminal growth rate, after 10 years of forecasted period-specific growth, is 10% per period. The terminal growth rate plays a large role in the current value of his site so changing it to 9% or 11% will make a considerable difference. The view from the analysts working for the purchaser or investor may feel that 9% is a better estimate, bringing down the current value. The negotiation process may leave them at a 9.5% terminal growth rate.

The terminal growth rate is not meant to only say “at this point growth levels out.” It also serves as a replacement for not having good predictable information to analyze period-by-period growth. For example, the analyst may know that three periods from now the site will launch a new section that will bring in x amount of additional ad revenues, or that next period they are switching hosting vendors which will reduce expenses, etc. After a certain amount of time into the future, many of these types of events cannot be predicted so a levelized growth rate must be established. Typically, the growth rate of an expanding business should climb at a less and less degree as time goes on, and then level off after a slight decline.

Keep in mind that what we are talking about are growth rates leveling out, not growth. To say that growth is flat is to say that the business is no longer growing. On the other hand, to say that the growth rate is flat typically means the business is mature and grows at a steady rate.

Another technique for determining a terminal value is to use the expected liquidation value. This method should be used in the specific situation where you know the business will most likely be liquidated after a certain amount of events happen in the future. This is not particularly common for websites since there are typically very few hard assets to be sold off. In any case, the terminal value would be the expected price one could receive for terminating the business and selling off the assets associated with it.

The market multiple approach to terminal value may be a decent approach to establishing a fair estimation of the website’s value at the end of the forecast horizon. We will discuss using the market multiple approach to establish the total value of a website later on. For the sake of the terminal value estimation let’s take a simplified preview of it. If the market is paying 25 times the annual cash flow for websites similar to the site being valued, the approach would call for backing in to that value at the end of the forecast horizon. Example: A given website valuation analysis has a 12 period forecast horizon with specific expected events that effect cash flow considered each of the 12 periods. The 13th period is the end of the forecast horizon and is where the terminal value is inserted. After detailed analysis and all the hard work is put into the 12 period-by-period sets of assumptions, it is no longer worthwhile to forecast specific events so a more simplistic approach is taken. I have mentioned it before, and will mention it again, the market multiple approach is a simplistic approach to website valuation. The method is of a lot more useful as a terminal value approach than using it for a full website valuation analysis. At the 12th period in the forecast the analyst will have a cash flow and earnings amount for the year. As stated, if the market is paying 25 times annual cash flow for similar websites, the 12th period (assuming the periods were years) cash flow multiplied by 25 would give you the terminal value. When the market multiple approach to website valuation is discussed later, I’ll address in more detail how to determine what the market is paying in terms of market multiples.

If possible, more than one approach should be used to establish a terminal value since it plays a significant role in the overall valuation of the website. If the perpetual growth model is used, a range of terminal growth rates should be analyzed.

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