In the finance world, there are roughly two ways of calculating the value of an asset; the market approach and the cash flow approach. You can valuate company X by comparing it to a similar company Y, by taking the ratio between the market value and operating profit or EBITDA or other financial measurements. Alternatively, you can come up with the best guess estimate of future cash flow from the company and use a discount rate to calculate the net present value. Now, calculating future cash flows is painful and calculating the discount rate can be even more of a pain the ass, whereas the multiple approach is much quicker because it makes one key assumption: the market value of the comparison asset is correct. The flaw with the market approach is that when the comparison asset is not valuated appropriately you are never going to get your valuation right. When the market is wrong everyone is wrong.
So being this is (sometimes) a blog about ad tech, why am I talking about this? Because I wanted to pose a question: When you are making your bid for an impression, what are you basing it on? Are we assuming that whatever the market is willing to pay for the impression is the “right” price? Are we bidding the current price plus a penny for an impression we want? You can already guess where I am going with this. What if we are pricing everything wrong? What if everyone is overpaying for those impressions?
Conceptually the cash flow method is simple. We should be valuating the impression based on how much the impression is expected to bring us in terms of revenue (or profit). Say you have a $100 product you have an ad for and you are willing to spend $10 to get someone to purchase it. If you knew for certain that a person has a 10% chance of buying your product by showing your ad, you should be willing to spend $1 on that impression. Now, as discussed in my older post An Efficient Market for Online Ads there are a few variables at play here:
- Click Through Rate (CTR)
- Conversion Rate (CVR)
- Average Order Value (AOV): the average value of the basket
- % of Sales I am willing to spend for a conversion
How much I am willing to spend on an impression can be expressed as: CPM = CTR*CVR*AOV*%Sales. These variables all have different variances meaning some variables are more predictable than others and how confident I am about the variances will affect how much I am willing to pay. The % of sales I am willing to spend is an internal decision that depends on my cost structure, capital structure, and appetite for risk. Given all this, the formula looks like this:
The above assumes last click attribution which is being really under fire these days (for good reason). I will share my thoughts on attribution on CPM pricing in another post, but the point here is, you should not assume whatever price the market is bidding for an impression is the price you should be willing to pay. Theoretically there is a “right” price you should be willing to bid for every impression, given the characteristics of the impression and your situation. Whether you act based on the market value or intrinsic value of that impression is up to you.