Posted by Gary Kinman in Business

Now that I've ranted on a few accounting shortfalls for the hosting industry I'm going to rant once more. I think that the way hosting companies must book the value of their assets per accounting rules shortchanges hosting companies. Some basic rules of finance clearly show the likelihood that significant value is missing on the financial statements.

Let's consider a mythical server that costs the company $10,000 to buy and the company depreciates it evenly over 3 years. After year one, the value on the financials is $6,667. After year two, its book value is $3,333 and finally $0 after three years. Suppose that the company deploys the server for five years. In reality, after three years, the server's true value is certainly above $0, and the hosting company is shortchanged by not being able to reflect this value on its financial statements. Multiply this effect by thousands of deployed servers and you can see that there is significant value in hosting companies that just isn't found on the financial statements.

So how should we reflect the value of a server? I would propose the use of a "capitalization rate" or "cap rate". This is a common method of appraising real estate and the formula is simple: take the projected net cash flow over the next 12 months and divide by the cap rate, and that's the value. So, what would happen if we applied this to a server?

Looking at our mythical $10,000 server above, for simplicity's sake, let's ignore any allocations of the switches, routers, generators, HVAC, etc., needed to operate it. Let's also assume it produces net cash flow of $100 per month and will do so for 60 months. Its 12 month projected net cash flow is $1,200. We would divide this by the cap rate to find its value.

Naturally, the next question is "what do we use for the cap rate?" For a given investment, the cap rate is the lowest return that an investor will accept for the given risk of that investment. In our server's case, the $10,000 investment produces a return of $1,200 per year. How much would an investor need to invest in lower risk alternatives to get the same return? For a risk-free investment of the same 5 year duration such as a 5 year Treasury Note at 4.25%, you would have to invest $28,235.29 to get $1,200 per year in return. If we use 4.25% as the cap rate in our scenario, the value of the server becomes $28,235.29. However, investors in hosting companies generally look for returns far above 4.25% and these returns are not without risk, so this is not the appropriate cap rate. For simplicity's sake, let's assume that the hosting company investor's minimum acceptable rate for the investment is 10%. In other words, if his investment in the hosting company was expected to return less than 10%, the investor has other lower risk options to invest and get a 10% return and he would not invest in the hosting company.

So if we use 10% for the cap rate in our mythical server scenario, the true value of the server is $12,000 ($1,200 / 10% = $12,000). As long as the 12 month projected net cash flow stays above $1,200 then that value holds constant. Check out the graph below to compare the value of this server from both the cap rate perspective and the accounting rules perspective over the five year life.

From month 36 to month 49, there’s a $12,000 difference in value between the two methods. If a hosting company has a thousand servers like this, that’s $12 million in value that isn’t reflected in the company’s financial statements. That’s huge.

-Gary