Updated: Feb 20
Many companies with subscription-based business models market themselves to investors on the number of users, customers, and subscribers they have acquired over years or could potentially acquire in the future. Despite the absence of sufficient information disclosure with respect to the subscribers of these companies, it is possible to use the intrinsic valuation approach (discounted cash flow valuation) to determine the value of a user. We generally value companies on an aggregate basis, calculating the aggregate cashflows of the entire business on a risk adjusted basis. It is also possible to use a sum-of-part valuation approach, valuing the divisions of the business that have separable cash flows and stand-alone earnings, aggregate the values of separate divisions, and bring closure to the valuation by tying the lose ends through integration of firm wide corporate expenses. This is also considered the dis-aggregate approach. When it comes to subscription-based businesses, the disaggregate unit is the user or subscriber. Hence the first step of valuing these companies under a user-based valuation approach is to determine the value of a user or subscriber to the business.
Many online, subscription-based platforms or social media companies such as Twitter, Facebook, Peloton, Snap, Netflix, Microsoft 365, Adobe, and other customer or subscription-based companies get their value from their large user base. Advertisers are drawn to the user base of these companies and are willing to pay advertising fees to get exposure to these users. This generates advertising revenues for these companies. Subscription membership fees on these platforms are another sustainable revenue stream. The revenue generated from transactions with the members of the platform is the third revenue stream. Hence there are three ways to generate income at these companies. Companies can draw on more that one of these models to generate revenue. Among subscription or user-based revenue models, a subscription or user-based model generates the more sustainable growth; a transaction-based model has the greatest potential for growing revenues from existing users; and advertising revenue model facilitates rapid growth in firm’s early days.
There are many issues that can be further discussed with respect to the valuation including the availability of information as it relates to users, accounting inconsistencies as it relates to the cost of user and customer acquisitions, and the diversity of these users. For example, the cost of acquiring new users is usually lumped into G&A costs while these costs should be treated like capital expenditure which can be capitalized and subsequently amortized over the life of the asset, since these expenditures add value to the firm’s long-term growth. Going to Pieces: Valuing Users, Subscribers and Customers paper by Professor Aswath Damodaran further discusses the issues as well as the valuation approach.
The value of a user is the present value of the cash flows the user generates over the lifetime the user is with the company considering the risks and the growth rate of those cash flows. Hence, factors such as immortality rate, churn rate or survival rates of users, customer lifetime, revenues generated by an existing user as well as costs of servicing the existing user, the cost of acquisition of new users, corporate expenses, and costs that can not be traced back to users (corporate drag) are important drivers of this method of valuation and cash flow calculations.
The valuation equation under the sum-of-part approach hence is:
We follow the three main steps:
1) We first value the existing user during the lifetime of the user; multiply this value by the number of existing users to determine the total value of existing users.
2) We determine the value added by new users by subtracting the costs of acquiring a new user from the value of a user in step one, estimating the number of the new users added on an annual basis and until perpetuity; multiplying the two to determine the cashflows added by new users annually and present valuing those cash flows. In determining the value, we consider the term growth rate and risk in the cash flows for present value calculations.
3) We determine the value of corporate drag which are expenses that are unrelated to users.
In the following Valuation of an Information Services/iGaming company, Royal Wins Corporation, we have explained the calculations and the inputs to the drivers of value for these three segments. For a comprehensive report on this company, Q1/22: Royal Wins, World’s First Licensed Real Money Pure Skill Gaming Platform, please see Basic Modelyze page.