By this time many of us wouldn’t have missed noticing the new Indian online web store www.flipKart.com. They are advertising these days heavily in almost every major TV channel as well as online portals / social media. Let us for the moment assume www.flipKart.com offers its share for Sale through IPO and you have an option to invest in it. Would you invest in it?
The key parameters to evaluate a typical online web-store like flipkart.com are below
- Average revenue it makes per customer
- Contribution margin per customer (product revenue – product variable cost)/ product revenue)
- Acquisition cost per customer
- Customer churn rate, percent
On the listed parameters, one and two are pretty straightforward to understand, three is the average money the company spends to attract one new customer (Advertisement & marketing expenses) and four is how long the customer remains loyal to flipkart.com for their purchases against switching to a competing online or offline stores
The primary logic to depend on the above than other conventional revenue or profit parameters / ratios are listed below
- Typically the growth potential to scale-up for these online web-stores compared to offline stores in future is very high (offline stores have a huge fixed cost to set-up their stores) and hence revenue can grow multi-fold in future without a need for a huge capital and
- Their current profits would be in red for many years due to very high sales & marketing expenses as they try to establish their presence in market space
The above is true for even http://www.amazon.com which was in red for many years before it started making profit. One of the well known secrets about all these newly launched online stores is that their current as well as future margins would be negative for many years as they spend a whole lot of money to attract new customers and their only hope on return on profitability in future are on basis of their ability to ensure their newly acquired customers would buy more and more from them and they can retain them as long as possible. That is true too as Amazon returned to profitability after many years betting on the same assumptions but those assumptions may not hold true for every new web-store. If these assumptions are true, then may be the exorbitant valuation these companies quote for IPO may hold good as they offer a significant year on year returns over a period of time, otherwise you have to forget your investment.
Let us try to analyse the above a bit more clinically with an example. Assume there are two flipkarts. One is loyalty.flipkart.com and another is turnover.flipkart.com. As the name suggests the loyalty.flipkart.com attracts new customer with less money and capable of retaining them for a long time by providing a better value for money. On the other hand turnover.flipkart.com has more revenue per customer and spends 25% more than the loyalty.flipkart.com to acquire a new customer & find it a bit difficult to retain their newly customer. Assuming both are coming to IPO, they make exactly same overall revenue and operating losses.
Now it become tricky to chose between these two as on one-hand turnover.flipkart.com makes better revenue per customer but struggling to acquire and retain new customers on the other hand loyalty.flipkart.com gets less revenue per customer but able to easily acquire new customers and retain the customer longer by offering better value for money. Also for time being let us assume both are able to acquire new customers at the same rate in future too as the market is big (scope for converting offline to online is high).
In this situation the best way to chose between them is to calculate the lifetime value of the customer. The details of the calculation are given below and the winner is loyalty.flipkart.com with net present value of customer lifetime value of ₹ 648.92 against turnover.flipkart.com’s ₹ -556.59.
So in future of you see investment options in these online companies look out for the above parameters and more importantly understand their value proposition to see how easily they can acquire and retain acquired customers in a sustainable manner. If you are not convinced on these parameters better don’t invest in it.
Adopted from the article: “Valuing dot-coms” by Driek Desmet, Tracy Francis, Alice Hu, M. Koller and George A. Riedal