This is probably the most important topic that I’ve yet to ever discuss in any of my financial writings: 100% profit growth does not lead to the same results for every type of business.
Let me give an example: Let’s say that over a century ago, you were Mr. Pemberton, and you started Coca-Cola. When you were growing your soda business, you were doing a magnificent thing because you were the owner of a business that could be capitalized at thirty, forty, fifty times profits.
Every time you doubled your profits, you were getting significantly richer. If you made $100,000 in soda profits, you could sell it for $3,000,000-$5,000,000. But if you doubled your profits quickly, say within the next three years, you could rapidly increase the wealth you could create by selling out. Suddenly, those $200,000 profits could be sold for $6,000,000-$10,000,000 (sadly, Pemberton sold Coca-Cola to a pharmacist for $2,500, but once a century passes, we can file that away into the “neither here nor there” category). The reason why a soda business capitalizes so well is because the profit margins are very high, there is a brand name that is intangibly growing as you increase your distribution, it’s easy scalable, the reinvestment costs are low, and so on. With businesses like that, holding on for a few more years before selling is often worth it because the premium on each dollar of profit is so substantial. If you own a business whose profits can capitalize upon themselves at a 20 or 40 rate, you have a strong incentive to ramp up profits a bit so that the time of sale will lead to you getting cut a much larger check.
But Coca-Cola is an extraordinary business. Most of us live within the world where typical businesses sell at a multiple between seven and fourteen times earnings (and some of them sell at multiples of revenues or sales depending on the industry). If you own an apartment complex of 100 units that charge $700 per month each, you are going to receive $840,000 in annual rental checks while probably having expenses around $240,000 or $340,000, depending on whether it is something that you run yourself or whether you go the complete absentee landlord direction that outsources everything and just wants to see a monthly check show up, free of hassle.
Depending on the location, you could sell an asset like that for somewhere in the ballpark of $5 million (I assumed $500,000 in net profit multiplied by a capitalization rate of ten). Yeah, that’ll get you through retirement just fine. But there is a reason why you see many owners of apartment complexes undergo an expansion project as their final masterpiece before going into retirement. Someone in this scenario, aiming to retire in five years, might pay the construction costs to create 50 more units that can charge $700 per month if the market will bear it.
Why? First of all, it gives you something to aspire towards. Marathon runners like to close with a sprint to a finish line, and businessmen approaching retirement tend to want to create that last masterpiece before letting go.
But the motive for creating those additional fifty units is not to simply generate $420,000 in rent checks in that final year before retirement. No, it’s about jacking up the capitalization rate of the asset. If you clear $300,000 or so in profits after expenses on that construction project, you just created another $3,000,000 in value come sales time. Not only did you get the personal satisfaction of embarking on a final last project before hanging up your landlord cleats, but you’re sailing off into the sunset with $8,000,000 (plus you have to pay taxes) instead of $5,000,000 (plus you have to pay taxes).
Smart businessmen, with an eye towards eventually selling, have this thought dancing around their heads that they rarely share with anyone else, “Every additional dollar in profit I make increases the value of my business by $10.” Yes, that’s an approximation rather than a precision, but dreams are drawn up on the backs of envelopes.
This brings me finally to today’s topic: websites. More than just about anything else (perhaps you can find some poorly placed gas stations that have lower cap rates), websites don’t get valued well at all. If you are very lucky, you’ll be able to sell it for three times annual profits. More typically, you’ll be able to sell it for 1-2x annual profits.
The reason why the capitalization rate is so low make sense: websites thrive and depend upon search engine results, which is a conditional love that can be lost at the first sign of a website’s grey hair or potbelly. It’s all intangible, and can disappear in a way that the local pizza parlor at the corner of Main Street cannot. When you own a cash-generating asset that does not capitalize well, you are usually best off holding onto the asset and using the cash thrown off to invest into things that capitalize better.
For someone who won’t contemplate selling, the $1,000 in monthly income generated by a website spends just the same as saving up $430,000+ to buy 4,300 shares of ExxonMobil. The Exxon shares come with many advantages: they don’t require work, are safer, have built-in growth, etc., but the current income generated spends just the same. Meanwhile, the website could only be sold for $36,000 in a best-case scenario, or $12,000-$24,000 in a typical case scenario. For someone thinking solely about the present utility of current income, it’s funny that a blog worth $12,000 could generate as much cash for you as an Exxon empire worth $430,000.
That’s why I shake my head a bit at some of the high-profile bloggers that have sold out of their websites in the past two or three years (or only disclosed that fact in the past two or three years). Yeah, I get the traffic can disappear, and yeah, I understand the burnout angle, and yeah, I understand that advertising revenue can be fickle during recessions, and yeah, I understand the appeal of what is called “a liquidity event” when someone turns their business into a big fat check, but it seems to me much wiser to maintain the cash generated by businesses that don’t capitalize well rather than trade it all in for a year or two of profits.
Think of it this way: A site making $1,000 per month could sell for $18,000 on January 1st, 2014. Or, assuming you can maintain profits (and sometimes this is a big assumption), you could wait until July of 2015, have your $18,000, and still own your business. When something is capitalized at a low rate, selling is obnoxious because you only have to wait a bit to get back your sell price. And, if the business is still growing its income and has not yet plateaued, the incentive not to sell should be even higher.
If you look at the people who get rich quickly in business, it’s the people who not only focus on creating profitable businesses, but have an eye on the capitalization rate as well. That’s why you’re seeing monopoly money effects in Silicon Valley; some of these companies aren’t making real profits, so the buyers make up values like 20x EBITDA to try and make the purchase sound palatable to their shareholders. If selling, rather than buying and holding something perpetually, is part of your game, then your analysis has another layer of complication: you have to keep in mind the capitalization rate of your business. Once it gets below 5x profits or so, you’re usually better off holding onto the asset and using the cash as an ongoing funding source to acquire more lucrative things.