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.

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