The idea of present value of future earnings is a long established concept in both academic finance and the practical business world. This is an extremely important concept to grasp in order to fully understand the reasoning behind website valuation. The underlying principle is that a dollar today is worth more than a dollar tomorrow. If you are already comfortable with the idea of an asset being valued at the present value of its future earnings, you can skip this section.

There are three primary reasons that a dollar today is worth more than a dollar at some point in the future:

1.) Inflation: The effect of inflation is that of reducing the purchasing power of the dollar (any currency for that matter). As time goes on, prices rise. Your dollar in your pocket today purchases more than that same dollar sitting in your pocket five years from now.

2.) Uncertainty of Getting a Dollar in the Future: A dollar today you have, it's in your possession and there is no doubt around whether it will be paid to you. A dollar promised in the future has a chance, however large or small, of not being delivered.

3.) Opportunity Cost: If you have a dollar today you can invest it and earn interest or some other return over time. If someone promises you a dollar in 5 years, it will be just a dollar upon delivery where the dollar today can grow into a larger amount in five years.

An asset's value is truly derived around what it can bring to the table. Whether that be in some salvage resale price or a continual stream of income is not important. In valuing a website, not unlike a private or public company valuation, you need to look at the income stream generated by the various tangible and intangible assets. These assets may be the actual code or databases on the site, the server it runs off of or the time invested by the owner to create the site. The idea that you tally up the current market value of these assets and use that total as a price is both inaccurate and downright foolish. The real value is in the future earning.

To make this concept clear, I'll discuss how fundamental stock prices are established in the real business world of investment banking. A company is a collection of assets that generates income, just like a successful website! Keep in mind that ultimately the market dictates teh actual selling price (i.e. what a person is willing to spend), but there is a distinct mechanism to get you there for every mature market.

It is common practice to establish a fundamental value on a large public company based on its future dividend payments. Not the value of the buildings, equipment, patents, etc...but simply the payments the company will generate to its owners/shareholders. In the case of the public company, there is a simple model known as the Gordan Growth Model or Dividend Discount Model. A simple web search will result in a fair amount of discussion and research surrounding these models if you're interested in more detail than what is discussed here. These growth models will essentially take into consideration the current stock dividend, the expected future growth of that dividend, and the expected/required return or the "discount rate." Mathematically, it is simply the current dividend multiplied by 1 + the growth rate, divided by the required return minus the growth rate. Sound crazy? It's not. The model assumes that the value of the assets is in the money they bring in going forward. The profits of a mature public company are paid out to investors in the form of dividends. The present value of those future dividends is equal to the fundamental value of the stock.

It is important to note that this model will not be used in our website valuation, but the underlying "present value of future earnings" will be intact. The spreadsheets that came with this book will do all of the math for you after some time is taken to review the data, make some assumptions, and plug it in the cells!

*quick example and terminology explanation: A stock is currently paying a dividend of $3.00 per year (dividend is a per-share payment to the shareholder and is taken from company profits). The expected return on the stock is 9% (the expected return is what a normal investor would expect to get as a return on his investment. The expected return is heavily determined by the risk associated with the business. For example, the expected return on a web start-up company would be much greater than the expected return on a 50 year old established utility company. We will learn how to calculate the expected return, or "discount rate" later and explore all of the factors involved. The expected long term annual growth of the dividend is forecasted to be 4%. That is, as profits rise, the company will increase it's payments to shareholders on average 4% per year. Doing the math we get the following:

$3*(1.04)/(.09-.04) = $62.4

The stock price is fundamentally valued at $62.40. (again, what an investor is willing to spend is what ultimately determines the price, but that is where "overvalued" or "undervalued" stocks come from.

To take it one step further in clarifying the growth and discount rates, let’s look at a couple scenarios. First, if the stock dividend was expected to grow more rapidly due to, let’s say a favorable new law or reduction of government regulations on the product the company sells, you would expect the stock price to rise. Here is the result of plugging in a 5% growth rate:

$3*(1.05)/(.09-.05) = $78.75

Now for the discount rate. All else held constant, if the company is riskier but the earnings are the same, you would be paying less for the stock because the earnings are at greater risk. For example, the industry has a high failure rate or its products are unproven. Why pay the same price for a stock or website that has a higher level of risk but the same earnings as another? Let’s plug in a higher discount rate to offset a higher risk investment. Using a discount rate of .12 and the same 4% growth (i.e. the investor would expect a return of 12% annually on this stock) we get the following:

$3*(1.04)/(.12-.04) = $39.00

The investor is compensated for more risk by a lower price. In reality what is often seen is higher risk means higher expected return.

The point here is that the investor is compensated for a higher level of uncertainty around earnings by a lower purchase price. This is a very simple model but it has stood the test of time in the financial world. We will consider much more detail and data points specific to websites but the underlying principle is the same and I explain this simply to convey the idea to the reader that present value of future earnings is a proven component of asset valuation techniques.

WEBSITE BUYERS AND SELLERS SHOULD DEBATE THE DISCOUNT RATE, NOT HOW MANY MONTH'S EARNINGS THE PRICE IS SET AT. THIS, MY FRIENDS, IS HOW MATURE REAL MARKETS WORK, AND HOW THE MARKET FOR BUYING AND SELLING WEBSITES WILL TOO.

After going through some more important website valuation model components we'll move on to taking a look at the spreadsheets that accompanied this book. The spreadsheets will do the math for you, you just plug in your data! It should be noted that the formulas are viewable and we’ll discuss all the components of the spreadsheets line-by-line for the reader to build her own spreadsheet or simply do the valuation with the good old fashion calculator and pencil.

Above is a sample. Read the full chapter.

Prowebvalue Blog: "Adventures in Buying Websites"

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Prowebvalue Blog: "Adventures in Buying Websites"