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.
Valuing Royal Wins Corporation in January 2022
We valued Royal Wins based on a sum-of-parts approach by determining the value of its existing users and new users it will acquire over time. Given management guidance, we forecasted the user survival rates to rise from 73% in 2021 to 95% by 2032 and churn rate to drop to 5% within the next ten years. We also assumed the average life of Royal Wins user to be ten years.
With a user base of 1.6 million, we determined revenues per existing user and grew Royal Wins average revenue per existing user by 10% for the next 5 years and gradually dropped the growth rate to 5% per year by the end of a user life. In order to arrive at the cashflows of existing users, Modelyze Investments also determined the cost of servicing the existing user. Given the most recent fiscal year’s operating expenses, we broke down the costs into costs associated with servicing existing subscribers (G&A costs and 20% of expensed technology costs), costs of getting new subscribers (marketing and advertising costs as well as capitalized technology costs which is assumed at 50% of total technology costs), and corporate costs or corporate drag (80% of expensed technology costs, salaries or other expenses, and the additional significant marketing-spend over the next 24 months as disclosed by the Management). All costs per user grew at inflation rate throughout the forecast period while expensed technology corporate cost grew at a higher rate of 5% per annum.
The value of the existing user is the present value of revenues less costs associated with the existing users, considering the risk in those cash flows. Given the high risk associated with firms in really early stages of their corporate life cycle, we chose a cost of capital of 9.88% for the first five years, which is at the 90th percentile of global companies in the Information Services industry, and we dropped the rate to 7.48% over the remaining years of the user life. With a marginal tax rate of 26.5% and given these assumptions, the value of 1.6 million existing users is $1.232 million. This is based on the assumption of 100% probability of going concern.
The value of a new user on the other hand is less than the value of an existing user due to the acquisition costs of the new user each time. By netting out the acquisition costs and forecasting the number of new users joining the platform over the next ten years, while considering the risk in those cash flows, as well as the terminal value of new users joining the platform till perpetuity, we determined the value of new users. Management expects to build a total player base of 4 to 6 million within the next 24 months, consequently, we assumed a target user base of 5 million by 2023FYE and grew the user count by 25% up until 2027, dropping this rate to 10% growth rate per year by 2032. In determining the number of users joining the platform on an annual basis, we also considered the churn rate and renewal rate to integrate customers leaving the platform. We capped the terminal growth rate of cash flows at risk free rate as over the long-term, real risk-free rate is a good proxy of real growth rate of the economy. Given these assumptions, the value added by new users is $125.5 million. This assumes 100% probability of going concern.
For corporate drag, we decrease the value of new and existing users by corporate costs and expenses that are not directly traced back to users over the forecast period including other expenses, salaries, 80% of expensed technology costs and the additional significant marketing-spend. The value lost due to corporate drag is $38.88 million. This is based on the assumption of 100% probability of going concern.
Given that only 30% of companies in start-up phase make it through the 10th year[1], and the fact that Royal Wins is in its really early days with $11.326 million reported comprehensive loss during the most recent fiscal year, the probability of Royal Wins continuing as a going concern in this valuation is assumed at 50%. In addition, like many young technology companies, Royal Wins compensates its managers, directors and employees with equity options. Modelyze Investments applied Black Scholes valuation approach to value these options and decreased equity values accordingly. With 115,506,941 shares outstanding and the assumptions with respect to the number of new users joining the platform, and revenue and costs per user, Modelyze Investments arrived at a target price (intrinsic value per share) of $0.38.
Download the valuation financial model of subscriber-based companies such as Royal Wins Corporation at Modelyze Store to have a better grasp of the inputs and drivers of value in these calculations.
[1] Source: NYU Stern
Source: