What is 'Value'?

Value is made when the future earnings of an online business exceed the cost of the invested capital. Thus, its value of consists of two elements: Future earnings and Cost of capital.

Future Earnings of an Online Business

An often heard objection to valuation methods such as the discounted cash flow and the adjusted present value is that the future is too uncertain to make assumptions. Accountants therefore are cautious and use realized earnings in the past. This assumption is understandable, but could also be seen as  incorrect. Because this assumes that the past is representative of the future.

The future is always uncertain and this uncertainty increases as you want to look further ahead. Obviously nobody can look into the future, but people with a sense of business can usually deliver an expectation for the next 2 to 3 years. When valuing online businesses, this is the common period of time on which valuation takes place. The period thereafter should be assessed conservatively.

E-commerce is a relatively young industry, in which dependencies are often high (as with Google search results) and the technical innovations follow each other in a fast pace. These elements obviously have a (substantial) influence on the value of a web store. That having said, an online business is relatively easy to transfer and the potential target audience is large because there are few geographical constraints. The acquisition of an online business often takes place based on a different valuation than, for example, an industrial company, even though the key figures can be comparable.

Because even the near future is uncertain, it is advisable to work with well-founded scenarios. Assume normal business operations, a best case scenario and a worst case scenario.

Another advantage of different scenarios is that the most significant risks come to light and opportunities can be recognized earlier in the process. Taking more then one scenario in consideration may prevents misery later on and make a valuation more useful.

Cost of Capital

Value is only created when earnings are larger than the cost of capital invested. These costs depend on a large number of variables such as the cost of the debt and the tax rate.

The essence of determining the cost of capital is as following: Return and risk go together. Higher risk should be rewarded with a higher return. Repayment of loan capital (bank loan) has priority over equity in case of a bankruptcy. In addition, the bank has generally requested for a collateral. As a result, debt is less expensive than equity.

Another advantage of debt is that its cost (interest) is tax deductible. From the point of view of fiscal optimization and value maximization, therefore, it makes sense to put the company into debt (as private equity does). This however increases the risk of bankruptcy, which will increase the cost of capital and might eliminate the benefit.

Read how to determine the value of an online business or calculate the value of your web store with our free module.

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