Metrics — Weighting the Metrics

Met­rics weeks con­tin­ues with a review of how to weight met­rics. So far, I’ve looked into who, in a com­pany could ben­e­fit from met­rics. I then delved into two dif­fer­ent types of met­rics: hard met­rics, which can eas­ily be mea­sured, and soft met­rics, which can­not. Today, I’m going to try to fig­ure out how this all weights out.

Group­ing the metrics

In order to fig­ure out weight­ing, I first started to think about how to group dif­fer­ent met­rics. For this pur­pose, I looked at things like the base value (which would give us a base­line as to how much a busi­ness is worth based solely on rev­enue and rev­enue growth), inven­tory (look­ing at things like traf­fic, reach, and out­put, because they all give us some data points as to the growth of mon­e­ti­z­able assets in the future), con­sumer involve­ment (look­ing at info like links, sub­scrib­tions, and com­ments to define the value of cus­tomers), and growth poten­tial (includ­ing some more fuzzy mea­sure of poten­tial growth and the advan­tages of the inte­gra­tion value).

My rea­son­ing for group­ing things in this way was that it might make it eas­ier to fig­ure out weight­ing across those large catch-all cat­e­gories (and, if there is any dis­cus­sion at all, I am sure that peo­ple will debate the per­cent­age assump­tion against those cat­e­gories). I, in no mean, try to rep­re­sent those as the be-all-end-all approach to val­u­at­ing a busi­ness. They are, at this time, the met­rics that give me the best com­par­a­tive view of a busi­ness, when I try to assess its value. How­ever, not being much of a met­rics guy to start with (my main rea­son for doing this series is to pro­voke debate among peo­ple smarter than me so there can be some con­sen­sus on met­rics in this new web 1+n.x world), I hope that oth­ers will step in and show me the error of my ways along with pro­vid­ing some inter­est­ing infor­ma­tion that will get all of us closer to some­thing useful.

Base Value

The base value, as I see it, is defined by rev­enue and rev­enue growth based on his­tor­i­cal data. The rea­son I would con­sider this to be the base value is that it is a reflec­tion of the busi­ness as it exists today and can pro­vide a base­line as to where the busi­ness would be headed if growth sud­denly slowed or invest­ment in the busi­ness stopped. It does not pro­vide any infor­ma­tion as to how to accel­er­ate the growth of the busi­ness and does not pro­vide more than a view into the present cash value of a business.

How­ever, for young com­pa­nies, such value does not pro­vide much infor­ma­tion. Start-ups, by nature, have a lower rev­enue and profit line than estab­lished com­pa­nies because they need to recover some of their ini­tial cost and may still be in high growth and research and devel­op­ment phases. As a result, to solely base one’s view of a busi­ness on its cur­rent abil­ity to gen­er­ate cash is short-sighted when it comes to start-ups.

Another ques­tion when devel­op­ing the base value is how to fac­tor in risks to the rev­enue base. For exam­ple, if the busi­ness relies pri­mar­ily on adver­tis­ing from an exter­nal net­work as its basis for rev­enue (many peo­ple have talked about busi­nesses look­ing to AdSense as the pri­mary source of rev­enue), one has to won­der what would hap­pen if the dynam­ics of that rela­tion­ship were to change.

As a whole, how­ever, because of its over­all impor­tance in assess­ing the present finan­cial value of a busi­ness, I would assume that the base value should rep­re­sent about 20 to 30 per­cent of the over­all value of a busi­ness. Ini­tially, the value would be in the 20 per­cent range because poten­tials are higher than the cur­rent rev­enue line but, as the busi­ness matures, and poten­tials decrease, it would edge up towards 30 percent.

Inven­tory

Inven­tory would be the next poten­tial group­ing of dif­fer­ent met­rics. In it, I would include traf­fic (and traf­fic growth), as well as vis­i­tors, site counts, reach, and out­put. Let’s go into more details on each of those.

Traf­fic is impor­tant because the num­ber of page views is some­thing that is mon­e­ti­z­able. How­ever, in a web 2.0 space, pageviews are not the only traf­fic met­ric one should track. For exam­ple, RSS sub­scriber counts is another use­ful value (and con­tro­versy has already swirled around ads in RSS feeds). How­ever, I would argue that there is one value in the inven­tory count that is of utmost impor­tance: access to an API. The rea­son I would ven­ture this is the most impor­tant inven­tory met­ric is that APIs, once imple­mented, are harder to unhook from. As such, they rep­re­sent a harder type of value since they solidy a site’s reach within a par­tic­u­lar mar­ket segment.

I believe that reach is actu­ally going to be seen as one of the more impor­tant val­ues in terms of inven­tory. The rea­son is that reach gives us an idea of the poten­tial growth oppor­tu­nity in a mar­ket. If a com­pany has a high reach in an indi­vid­ual mar­ket, its poten­tials are more lim­ited. Wit­ness, for exam­ple, a com­pany like Netscape, which once had a reach of 80% (ie. 80% of all inter­net users were using it. ) Tac­ti­cally, this kind of posi­tion is one where they should have been on the defen­sive, the rea­son being that there was more poten­tial of a drop in their reach than an expan­sion of it. Microsoft is now find­ing itself in the same posi­tion on a num­ber of fronts: Win­dows, Office, Inter­net Explorer are all play­ing in a world where they will not reach a higher per­cent­age of the mar­ket. As a result, they are forced to play defen­sively. One could argue that web 2.0 com­pa­nies, with their reach APIs and more pow­er­ful front ends (thanks to tech­nolo­gies like AJAX) are rep­re­sent­ing the threat Microsoft saw com­ing from the Inter­net in the mid-90s. And one could argue that, this time, the posi­tion they’re in (ie. largest player) is endan­ger­ing their future if they don’t make a rad­i­cal change (because they can’t grow from the posi­tion they’re in).

Going beyond the reach, which pro­vides some infor­ma­tion on past growth and poten­tials mov­ing for­ward, one has to look at out­put from the com­pany. For exam­ple, in the case of a com­pany like Ebay (arguably a web 2.x com­pany already), the inven­tory is num­ber of auc­tions sub­mit­ted. Sim­i­larly, in the case of Craig’s List, it would be num­ber of new ads posted, or in the case of a blog, the num­ber of posts cre­ated. One has to be care­ful about ouput, how­ever, and should mea­sure the cost of out­put in order to fig­ure out whether the out­put is good or not. In the case of web 1+n.x com­pa­nies, out­put is a very good thing as it is gen­er­ally cre­ated by out­side par­ties for free. That free prod­uct is one that those com­pa­nies then mon­e­tize. How­ever, one has to be care­ful and eval­u­ate if out­put is out­pac­ing the company’s abil­ity to mon­e­tize it because, if an imbal­ance were to start exist­ing, the value of the out­put could poten­tially decrease.

All and all, because inven­tory has a mea­sur­able value and, in gen­eral, is the very thing that a com­pany will mon­e­tize, I would guess its weight, when fig­ur­ing out the value of a com­pany would prob­a­bly sit in the 10–15 per­cent range.

Con­sumer involvement

Con­sumer involve­ment, which was known in the past as stick­y­ness, is another major group of met­rics. This sec­tion would include links, sub­scrip­tions (both to RSS or API feeds and, if offered to any paid type of ser­vice), and any type of inter­ac­tion a user may have with a sys­tem. For exam­ple, if you try­ing to get some inter­ac­tion infor­ma­tion on con­sumers of a blog, one could look at num­bers of com­ments posted. Alter­nately, if you’re look­ing at a search engine, one could look at num­ber of searches per­formed. Or, if you’re look­ing at a com­pany which offers an API, you could look at the num­ber of times that API has been inte­grated in other prod­ucts and the num­ber of times it is accessed.

I would ven­ture to say that this met­ric is one of the most impor­tant ones when assess­ing the value of a busi­ness. The rea­son I would value it higher than the ones I men­tioned ear­lier is that this is where one can see whether a busi­ness has a poten­tial or not. The inter­ac­tion with cus­tomers (either directly or via APIs) pro­vides so much use­ful infor­ma­tion that a com­pany not look­ing at this met­ric is prob­a­bly off track in terms of eval­u­at­ing itself (and, gen­er­ally con­sid­er­ing the hype around new busi­nesses, such com­pany could fool itself into extinc­tion as it fails to see major issues aris­ing out of the increase or decrease in con­sumer involvement.)

Because it rep­re­sent the value of the exist­ing cutomer base and pro­vides some input as to the trends sur­round­ing that cus­tomer base, I would throw a weight of 30–35% of an over­all val­u­a­tion going to fac­tors relat­ing to con­sumer involvement.

Growth poten­tials

How­ever, met­rics in and off them­selves, are pretty use­less as a point in time num­ber. As a result, one has to assume the growth poten­tial when eval­u­at­ing a busi­ness. The growth poten­tial can be asso­ci­ated in a num­ber of ways but, when it comes to web 1+n.x prop­er­ties, it comes down more on the side of poten­tial based on a num­ber of sub­com­po­nents. In the inter­est of pro­vok­ing more con­tro­versy, I would ven­ture that there is a for­mula to cal­cu­late poten­tial and that it is as follows:

Poten­tial = traf­fic growth rate * rep­u­ta­tion vec­tor * brand equity vec­tor * (inte­gra­tion vec­tor (squared)) — ( Risks vec­tor / per­cent­age of risk that can be mitigated)

In the growth rate area, I would put an aggre­gate growth rate that aver­ages out growth rates over a period of time (6 months to a year if you are com­put­ing a monthly growth rate.) The rep­u­ta­tion vec­tor and brand equity vec­tor would be val­ues based on rep­u­ta­tional and brand equity trends, which I talked about in a pre­vi­ous entry. You will notice that I con­sider the inte­gra­tion vec­tor to be of such high impor­tance, when defin­ing poten­tial that I’ve decided to square its value. I will talk about inte­gra­tion vec­tors in a future entry but, put short, the inte­gra­tion vec­tor is the magic glue that makes acquir­ing or merg­ing a com­pany very valu­able because inte­grat­ing it with another com­pany will derive greater value for the com­bined entity. It is that issue gen­er­ally known as syn­ergy but try­ing to put a value on it would have the poten­tial of mak­ing for bet­ter, more suc­cess­ful acqui­si­tions and merg­ers. Last, but not least, is the rist side of the equa­tion. Because risks have a huge impact on poten­tials, it is impor­tant to mea­sure them in order to get an idea as to their poten­tial impact. How­ever, because some of the risks can be mit­i­gated, it is impor­tant to cap­ture this fig­ure in order to assess the impor­tance of dif­fer­ent risks.

Ulti­mately, growth poten­tials rep­re­sent the largest part of any equa­tion when try­ing to value a com­pany. Few com­pa­nies are bought with­out an expec­ta­tion of poten­tial and this is why, in my weight­ing, I would assume poten­tial to rep­re­sent a sub­stan­tial (30–40%) part of the equa­tion when try­ing to mea­sure a company’s value.

Con­clu­sion: Wait, that’s more than 100 percent

If you do the math, it appears the dif­fer­ent weight are end­ing up rep­re­sent­ing more than 100%. The rea­son is that those are ranges. How­ever, the truth is that, in any busi­ness deal­ing, there is also an amount of faith and luck that comes in. For exam­ple, I sat in a meet­ing once where an indi­vid­ual was given an option to buy in whole a com­pany which is now very suc­cess­ful on the Inter­net for around a mil­lion dol­lars. Look­ing back, it might have been worth that much at the time but I doubt that it would be worth what it is worth now (sev­eral bil­lion dol­lars) had that deal being con­su­mated. Over time, the man­age­ment of that com­pany was smart enough to mine oppor­tu­ni­ties and put peo­ple in place that helped them real­ize huge growth. Had that com­pany been in the hand of more con­ser­v­a­tive (and by con­ser­v­a­tive, I mean adverse to risk) investors, it would prob­a­bly not have flour­ished in the same way.

Hav­ing gone through a few days think­ing about met­rics, it is clear that there are a num­ber of oppor­tu­ni­ties for peo­ple smarter than me to fig­ure out some solid met­rics in assess­ing the value of new com­pa­nies. Met­rics, how­ever, should not be the sole guide when assess­ing a company.

Many peo­ple have asked me why I both­ered to look at such bor­ing sub­ject (and why I’ve been blog­ging so inces­santly about num­bers lately). My main rea­son­ing is that one of the fail­ures in Web 1.0 (the bub­ble we lived through in the 90s), lack of account­abil­ity and/or expec­ta­tion man­age­ment lead to very inflated num­bers that even­tu­ally left a lot of investors with very poor invest­ment. Hav­ing lived (and sur­vived) that bub­ble, I want peo­ple to start think­ing more crit­i­cally about Web 2.0 com­pa­nies and, hope­fully, we can all learn about the mis­takes of the past and avoid over-hyping new com­pa­nies into extinc­tion… because for every bub­ble, there is even­tu­ally a big pop, and no one really enjoys that part.