Master Of Science

Valuing internet firms with advertising revenue

Valuation of internet firms is a very specific area in financing. Valuating a business that is solely doing its business online can be valued in a variety of ways depending on the business model of the website. Below I will identify the types of business models a website can have, of course some website have multiple models.

Content site (no current revenue model) - The value of such a website is based on the Value of the domain name, the value of content and the value of backlinks.

Content site (advertising revenue model) - Valuating a content website with an advertising revenue model is based on future traffic projections and earnings based on past earnings/net income per unique visitor or based on multiples of annual revenue.

Subscription site - Value is based on current mailing and subscription base. A calculation of the number of users times the average time they are subscribed, also taking into account the way the website is able to adjust to change.

Service site - based more on traditional business model of a service company.

E-Tailor - Net sales or profit times the time period desired

Central question:

How can content websites with an advertising revenue model be valuated?

1. Content websites and advertising income

The content of website's (in this paper also referred to as portal and content/community website's) with advertising revenue can vary a lot. Search engines are content websites, often their advertising revenue comes from sponsored search results. Let's take Google as an example, their advertising income is based on sponsored links to other web publishers that relate to a specific search term.

Research by Interactive Advertising Bureau and Price Waterhouse Cooper (2004) concluded that search advertising is by far the largest piece of online ad spending

After search advertising, display ads is the method most used in online advertising. News website's are also content website's. They mostly generate income by providing display space in which all kinds of companies can display their visual and sometimes interactive expressions. CPM (Cost per 1,000), CPC (Cost per Click) and CPA (Cost per Action) are methods of calculating the charge for pages (advertisements) being served. CPM is a holdover from traditional media advertising, and does not take advantage of the Hypertext nature of the medium. It charges purely on the number of times the advertisement is served. It does account for branding effects that are not accounted for in the other models. CPC is a cost associated with each click on the advertisement to the target page. CPA is a cost associated with each lead created from a click on the advertisement (CPL), or each sale (CPS). Both CPC and CPA are much more accountable means of developing a price for the banner, and either are also used for affiliate programs. They become a variable cost in terms of generating the number of people exposed to the target page, the number of leads generated (CPL) or the number of sales (CPS). The downside for the vehicles is they do not control the design of the banner (poor design = low click-through etc.) and they are not rewarded for the branding effect of the banner. The options for displaying ads are set by the standards of the interactive advertising bureau. These are their standards (http://www.iab.net/standards/adunits.asp, 22-7-2007):

There is also a range of relatively new ways of advertising called rich media. These are all initiated by users and can be in-page or over-the-page units. See the table below to see the variations and characteristics of these advertising media.

2. Breaking down the valuation

Internet firms, and especially portal, community and content sites with advertising income business models are often hard to valuate. A reason for this lies in the ratio of intangible assets the firms owns in comparison to the tangible ones. The large amount of intangible assets like intellectual property (patents or unhackable technologies), the people working at internet firms, the brand value and goodwill creates a market value/book value ratio that is larger then most other industries (Dewan, Freimber, Zhang, 2002). Historical data also show that internet firms have been sold at high prices with relatively low operational performance. The valuations seem to be based more on non-financial user data then financial accounting information. A famous example is the Youtube acquisition by Google for an astronomic amount of 1.6 billion, see this video for a review of Youtube's history http://www.youtube.com/watch?v=x2NQiVcdZRY. Another good example is Amazon, which had a market capitalisation of 22.2 billion although it had been unprofitable since it started doing business online.

I will now describe 4 ways of valuing an internet firm.

2.2 Relating an Internet firm's value to its historical financial and non-financial data.

One way for calculating the market value of both e-tailor and p/c firms is using the residual income model by Ohlson (1995) combined with usage data.

= Market value at time 't'

= Book value at time 't'

= Expectation factor

= Residual earnings at time 't + i'

= Return rate required on equity capital

Earnings are calculated by the following formula:

= Gross profit at time 't + i'

= Operating expenses at time 't + i'

= Non-operating expenses at time 't + i'

Next, the expectations of investors are tied to the components of eanings based on the financial accounting information and the website usage information. This is a few assumptions. First, Trueman, Wong and Zhang (2000)