Friday, August 28, 2015

Big Markets, Over Confidence and the Macro Delusion!

In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.

Big Markets! Really, Really Big Markets!
Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.

It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:

China: A billion-plus people makes any market large, and if you add rapid economic growth and a
burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.
Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.

The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use. 

The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.

I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the "mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.

The Macro Delusion: Individual Rationality, Collective Irrationality
When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).

To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.

Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.

Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision. 

To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.

Let's now add the twist that causes the deviation from rationality and make both the entrepreneurs and VCs over confident, the former in the superiority of their products over the competition, and the latter in their capacity to pick winners. This is neither an original assumption, nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and venture capitalists) attract over confident individuals.  The game now changes, since each business cluster (the entrepreneur  and the venture capitalists that back his or her business) will now over estimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses that are targeting the big market will be collectively over valued. Second, the market place will become more crowded and competitive over time, especially with new entrants being drawn in because of the over valuation. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at firms will fall below collective expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, where the entrepreneurs and VCs will be well rewarded for their investments.

The collective over valuation of the companies in the big market will bear resemblance to a bubble, and the correction will lead to the usual hand wringing about bubbles and market excesses, but the culprit is over confidence, a characteristic that is almost a prerequisite for successful entrepreneurship and venture capital investing. That is one reason that I feel no need to inveigh against bubbles in the social media space, since this is a feature of investing in young, start-up businesses in big markets, not a bug. That said, the extent of the over pricing will vary, depending upon the following:
  1. The Degree of Over Confidence: The greater the over confidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the over pricing. While both groups are predisposed to over confidence, that over confidence tends to increase with success in the market. Not surprisingly, therefore, the longer a market boom lasts in a business space, the larger the over pricing will tend to get in that space. If fact, you can make a reasonable argument that the over pricing will be greater in markets where you have more experienced venture capitalists and serial entrepreneurs.
  2. The Size of the Market: As the target market gets bigger, it is far more likely that it will attract more entrants, and if you add in the over confidence they bring to the game, the collective over pricing will increase.
  3. Uncertainty: The more uncertainty there is about business models and the capacity to convert them into end revenues, the more over confidence will skew the numbers, leading to greater over pricing in the market. 
  4. Winner-take-all markets: The over pricing will be much greater in markets, where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares. Since the payoffs to success is greater in these markets, misestimating the probability of success will have a much bigger effect on value.
The Online Ad Market and Social Media Company Valuations
The market that best lends itself to run this experiment today is the online advertising market, with the influx of social media companies into the marketplace in the last few years. To run my experiment, I took the market capitalization of each company in the online advertising space and backed out of the expected revenues ten years from now. To do this, I had to make assumptions about the rest of the variables in my valuation (the cost of capital, target operating margin and sales to capital ratio) and hold them fixed, while I varied my revenue growth rate until I arrived at the current market capitalization. 

The figure below illustrates this process using Facebook with the enterprise value of $245,662 million from August 25, 2015, base revenues of $14,640 million  (trailing 12 months) and a cost of capital of 9%. Leaving the existing margins unchanged at 32.42%, we can solve for the imputed revenue in year 10:
I assume that Facebook's current proportion of revenues from advertising (91%) will remain unchanged over the next decade, yielding imputed revenues from advertising for Facebook of $117,731 million in 2025. The assumption that the advertising proportion will remain unchanged may be questionable, at least with some of the other companies on the list below, where investors may be pricing in growth in new markets into the value. You undoubtedly will disagree with this and some of my other assumptions, which is why I will let you make your own in the attached spreadsheet and solve for your estimate of future revenues.

I repeat this process with other publicly traded companies with significant online advertising revenues, using a fixed cost of capital and a target pre-tax operating margin of  either the current margin or 20%, whichever is higher, for every firm. Note that both assumptions are aggressive (the cost of capital may have been set too low and the operating margin is probably too high, given competition) and both will push imputed revenues in year 10 down.
Numbers & Valuations in US dollars for all companies (Folder with valuations)
The collective online advertising revenues imputed into the market prices of the publicly traded companies on this list, in August 2015, was $523 billion.  Note that this list is not comprehensive, since it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being imputed into the valuations of private businesses like Snapchat, that are waiting in the wings. Consequently, I am understating the imputed online advertising revenue that is being priced into the market right now.

To gauge whether these imputed revenues are viable, I looked at both the total advertising market globally and the online advertising portion of it. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising (Sources: Zenith Optimedia. eMarketer). The growth rate in overall advertising is likely to reflect the growth in revenues at corporations, but online advertising as a proportion of total advertising will continue to increase. In the table below, I allow for different growth rates in the overall advertising market over the 2015-2025 time period and varying proportions moving to digital advertising to arrive at these estimates of digital/online advertising revenues in 2025:
Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 is expected to be $466 billion. The imputed revenues from the publicly traded companies on my list is already in excess of that number, and it seems reasonable to conclude that these companies are being over priced, relative to the market (online advertising) that they are expected to profit from.

As more companies line up to enter this space, this gap between the size of the market that is priced in and the actual market will continue to grow, but investors will continue to fund these companies, even if they are aware of the gap. After all, the nature of over confidence is that founders and investors are convinced that the over pricing is not at their firms, but in the rest of the market. There are two threats to this over confidence and they are inevitable. The first is that as companies in this space continue to report earnings and revenues, you will see more negative surprises (lower revenue growth, shrinking margins and more reinvestment) and some price adjustment. The second is that there is no better deflator of investors over confidence than a market panic, and if the China crisis does not do it, there will be others down the road.

What now?
Even if you accept my argument that big markets can create macro delusions and that these delusions can lead to a gap between collective expectations and reality, what you should do, in response, will depend on how you approach investing. If you are a trader, playing the pricing game, you may not care about the gap, since your returns will be based on timing, i.e., entering the market at the right time and exiting before the delusion is laid bare. It is possible that a lot of public investors and venture capitalists in this space are playing this pricing game and some of them will get very rich doing so. 

If you are a founder/owner or private investor interested in the long term value of your business, you may not be able to do much about your over confidence but there are a few simple steps that you can take to keep it in check. I do know that many in the start-up community view intrinsic valuations (or DCFs) with suspicion, but done right, a DCF is more than a valuation of a company. It provides a template for how you hope to convert products/users/downloads into revenues and profits, how much capital you will need to deliver the growth you so eagerly seek, and how competition will impinge on your best laid plans (by affecting growth and margins).  

If you are a public market investor, surveying a "big market" group of companies, this post is not a clarion call to abandon the group, but to approach it differently. You can still make money investing in this sector, but only if you are selective about the companies that you invest in (which requires that you grapple with estimating the size of the big market and make your best judgments on winners and losers)  and are cognizant of the price that you are paying, not only when you buy the stock but while your hold it. In fact, your very best investments may come from mis-pricing in this segment.

No matter which group you belong to, it is time that we stop labeling each other. If you are on the outside (of these big markets) looking in, don't be so quick to categorize players in the market as irrational, shallow and naive. If you are on the inside looking out, stop thinking of anyone who does not buy into your big market thesis as a Luddite, out of touch with technology and stuck in the past. You and I should be able to disagree about the values of Uber, Snapchat and Twitter, without our motives being impugned, our intelligence questioned and our sanity put to the test.

YouTube Version
I know that this is a long post and that your attention may have flagged half way through. To remedy that, I decided to make a YouTube video around this post. I hope you enjoy it!

  1. Imputed Online Ad Revenues by Company (with raw data on the companies)
  2. Spreadsheet to compute Imputed Online Ad Revenues
  3. Folder with imputed revenue spreadsheets for companies


Vijay said...

Thanks for the great post Professor. Just looking at Imputed online ad revenue/ Current revenue for all the US companies, Twitter seems to be most out of line with expected revenues that are required to achieve current valuation (~12, compared to Facebook at 8). Given that you just bought into Twitter at current prices, how would you resolve the apparent excessive expectations of Tw revenue through this analysis?

Anonymous said...

Sir Aswath Damodaran what a great article have clearly explained the crazy valuation of e commerce companies in emerging markets. I know many intellectuals who are fan of highly complicated modelling skills but the simplicity with which you explain complicated topics is simply unparalleled.

Aswath Damodaran said...

Good point, but here is the difference. I think that there is consensus that Twitter, right now, is doing an awful job monetizing its user base and that Facebook is doing a really good job. That is what is reflected in current revenues. It is true that the breakeven revenues tell us what is needed in Twitter is a major rethinking of business models and perhaps new management, but I think that it is doable. With Facebook, where excellence is already reflected in the current numbers, it will be a much tougher challenge maintaining and growing that excellence.

Anonymous said...

Most out of line seems to be Yahoo where market cap of its core business is virtually nil, with entire market cap is represented by its stake in Alibaba. Is that correct Prof?

Aswath Damodaran said...

You are right on the Yahoo number, I should back out the Alibaba and Yahoo! Japan holdings. In effect, I am double counting them right now.

steve said...

Hi: Am not sure where to ask this question, so I will do so here.
You favor building a bottoms up beta vs public data and your reasoning is quite sound. My question is this: have you in a recent valuation compared the valuation difference between your bottom up beta vs using a published beta, say on Yahoo finance(assuming there is one for the company u are valuing ) and how material a difference is there? If it is no more than 10-15%, I am not sure a public beta would not suffice.
Thank you

realist said...

Professor, thank you for the great analysis in this post.

I do have an issue with the range of CAGR's that you've chosen for overall advertising revenue. I would expect, at least as a base case, for advertising revenue to more or less track nominal GDP growth. (I would in turn also expect your stated driver - total corporate revenue growth - to more or less track nominal GDP growth.) I therefore think that 5% should be roughly the midpoint of your table, not a high case assumption. I'm arriving at 5% based on a back of the envelope assumption of 2% annual inflation and 3% real GDP growth.

Shan Rajasekaran said...

Prof. Damodaran, thanks for the great article and reality check.

One thing that will further undermine online advertising revenues is the emergence of ad blockers like Ghostery. Apple's iOS 9 will introduce content blocking too. (Google, of course, has been quick to educate their developers on how to bypass that). These trends will lead to less personalised (and hence less valuable) advertising.

Here's an article from WSJ on the growth of ad blockers.

Unknown said...

Would the valuations be entirely explained by expectations of growth from current business model or expectations of.leadership and management being able to generate benefit for shareholders from a virtuous innovation cycle which will transform the business. Google itself now has future growth engines and so does every technology company. Perhaps the question is naive in the sense these expectations have no quantifiable basis so do not lend themselves to quantitative analysis. I agree with the issue of hype. But there is also hope valuations here

Regina Morales said...

I feel like one of the largest issues with large markets is that they are not exploited properly. Twitter does have a huge market, but it has not posted a profit despite having significant revenues. A lot of these big markets, like uber and the cloud, just can’t be thought of from a traditional perspective, and that’s where a lot of investors go wrong.

Regina Morales @ Sonic Response