Value investing has traditionally centered on stability and predictability, with investors relying on tried-and-tested financial metrics like the price-to-earnings (P/E) and price-to-book (P/B) ratios to gauge a company’s worth. This approach, however, often leaves them puzzled by the high valuations of tech companies that are profitable or even worse that operate at a loss for extended periods. A value investor would try to find the reason behind these high valuations. A concept not fully captured by traditional metrics of valuation: Network Effects.
Take, for example, companies like Uber and Airbnb. Both have leveraged network effects to grow their value exponentially. Uber, despite years of financial losses, has revolutionized transportation by increasing the number of users and drivers, which enhances the utility and attractiveness of its platform. Similarly, Airbnb has transformed the lodging industry by creating a platform where more listings attract more users, which in turn encourages more listings. This self-reinforcing cycle boosts the platform’s value, far beyond what traditional financial indicators might suggest.
Another case is social networking websites like Instagram, Whatsapp and Snapchat, which initially puzzled many traditional investors with their lack of revenue and unclear path to profitability. However, their value lies in their large, engaged user base, predominantly among younger demographics highly coveted by advertisers. The companies’ ability to monetize the user base through innovative advertising formats shows how traditional metrics might underestimate the potential financial upside of tech companies heavily reliant on network effects.
Cryptocurrencies present an even more stark example of the challenge for value investors. Bitcoin, for example, operates with no central authority or physical backing, deriving its value purely from the network of users who accept and trade it. Its value increases as more people use and trust the system. This concept is difficult to reconcile with value investing principles that rely on physical assets and clear cash flows.
In a new book published by Bloomsbury India, “Digital Fortunes: Value Investing in the New Economy”, Smarak Swain argues that the reluctance of value investors to engage with tech stocks and cryptocurrencies stems from a fundamental misunderstanding of how these entities create value. Swain, who has been engaged for years in multilateral negotiations to develop international standards on taxation and regulation of the digital economy, talks about the notion of network effects as a crucial analytical tool for understanding the fundamentals of tech companies and virtual assets. This approach helps investors differentiate between tech companies with solid growth potential and those likely to falter once the initial hype fades.
Swain provides a compelling argument that as the global economy continues to digitalize, understanding these dynamics is not just beneficial but essential. For instance, the meteoric rise of companies like Facebook and Amazon showcases how traditional metrics such as immediate profitability and early financial stability are not always predictors of long-term success in the tech sector. Both companies focused on long-term goals. Their strategies, which initially involved heavy investment and losses, eventually redefined their respective industries through strong network effects and scale economies.
As the tech landscape evolves, Swain’s insights are invaluable for value investors looking to adapt their strategies. The key takeaway from “Digital Fortunes” is that while the fundamentals of investment might remain the same—seeking value and minimizing risk—the tools and understanding required to identify these opportunities must evolve. Recognizing the importance of network effects in the valuation of tech companies and virtual assets is critical for making informed investment decisions in a digital economy.
For value investors open to adapting their methodologies, the tech sector and the world of cryptocurrencies offer fertile ground for potentially high returns, provided they can see beyond traditional metrics and appreciate the new dynamics at play by looking at some potential forward looking indicators to ascertain the probability of network effects and platform economics playing out:
1. Market Dominance: Priority lies in identifying businesses that are the dominant players in their respective sectors, particularly as platform-based models often operate on a winner-takes-all basis.
2. User Base Growth: Exponential expansion of the user base signals potential value, especially when the market size is substantial and not confined to specific demographics or regions.
3. Customer Acquisition Costs (CAC): Declining CAC, especially as growth accelerates, indicates efficiency in acquiring new users and reinforces the scalability of the business model.
4. Profitability Indicators: Signs of profitability at critical stages such as Contribution Margin 1 (CM1), Contribution Margin 2 (CM2), and a clear path towards Contribution Margin 3 (CM3) or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), underscore the sustainability and viability of the venture.
By scrutinizing these forward-looking indicators, value investors can better assess the potential impact of network effects and platform dynamics, thereby making informed investment decisions in the ever-evolving digital economy.
Mahesh is Head of Products & Investment Advisory in Ambit GPC, and 40Under40 2020. Views are personal.
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