Possible, Plausible and Probable: Big markets and Networking effects

I do not know Bill Gurley personally, but I do know of him, and I was surprised, sitting in Vienna airport waiting for a connection home on Friday morning, to get an email from him. In the email, he graciously gave me a heads-up that he was planning to post a counter to my Uber valuation and that it would not pull punches. A little while later, I started getting messages from those who had read the post, with some seeking my response and some seeming to view this as the first volley in some valuation battle. I read the post a few minutes later and the first person I wrote to after I read it was Bill Gurley and I told him that I absolutely loved his post, even though it was at complete odds with my assessment of the company, for two reasons.

1. Like anyone else, I like being right, but I am far more interested in understanding Uber's valuation, and the post provided the vantage point of someone who not only is invested in the company but knows far more about it than I do.  Rather than berating me for not getting "it" (technology,  the new economy, progress) or abusing valuation as a tool from the middle ages, the post focused on specifics about Uber and the basis for its high value. 
2. In this earlier post of mine, I argued that good investing/valuation is the bridge between numbers and narrative and that neither the numbers nor the narrative people have an automatic right to the high ground. Bill Gurley's post brought home that message by laying out a detailed and well-thought-through narrative, backed up by numbers. 

Mr. Gurley's narrative lends itself well to a more grounded discussion of Uber as a company and I am grateful to him for providing it. As a teacher, I am constantly on the lookout for "teachable moments", even if they come at my expense, and I plan to use his post in my classes.

Dueling Narratives

In my post on Uber's value (and in the Forbes and 538 versions of it), I laid out my narrative for Uber.  I viewed Uber as a car service company that would disrupt the existing taxi market (which I estimated to be $100 billion), expanding its growth (by attracting new users) and gaining a significant market share (10%). The Gurley Uber narrative is a more expansive one, where he sees Uber's potential market as much larger (drawing in users who have traditionally not used taxis and car services)  and much stronger networking effects for Uber, leading to a higher market share. In many ways, this is exactly the discussion I was hoping to have when I first posted on Uber, since it allows us to see how these narratives play out in the  numbers. In the table below, I contrast the narratives and the resulting values:

You can download the valuations by clicking here. (Uber (Gurley) and Uber (Damodaran)).

Given that the values delivered by the narratives are so different, the question, if you are an investor, boils down to which one has a higher probability of being closer to reality. If you had to pick one right now, I think Mr. Gurley's has the advantage over mine for at least three reasons. The first is that  as a board member and insider, he knows far more about Uber's workings than I do. Not only are his starting numbers (on revenues, operating income and other details) far more precise than mine but he has access to how Uber is performing in its test markets (with the new users that he lists). The second is that as an investor in Uber, he has skin in the game, and more at stake than I do and should therefore be given more credence. The third is that he not only has experience investing in young companies, but has been right on many of his investments.

Does that mean that I am abandoning my narrative and the valuation that goes with it? No, or at least not yet, and there are three reasons why. First, it is difficult, if not impossible, for someone on the inside not to believe the best about the company that he directs, the managers he listens to and the products that it offers. Second, an investor in a company, especially one without an easy exit route (at least at the moment), is more attached to his or her narrative than someone who has little to lose (other than pride) from abandoning or altering narratives. Third, as Kahnemann notes in his book on investor psychology, experience is not a very good teacher in investing and markets. As human beings, we often extract the wrong lessons from past successes, don't learn enough from our failures and sometimes delude ourselves into remembering things that never happened. I am not suggesting that Bill Gurley is guilty of any of these sins, but I am, by nature, a cautious convert and I will wait to buy into his narrative, compelling though it may be.

The Acid Test: Probable, Plausible and Possible

As I noted at the start of this post, I liked Bill Gurley's post because it offers a coherent narrative that leads to a higher value. The narrative has two key building blocks and I think that there is much to be gained by taking a closer look at them. The first is that Uber is pursuing a much larger market than just taxi service and that it may very well redefine the nature of car ownership. The second is that Uber will have networking effects that will allow it to capture a dominant market share of this larger market, well above the 10% that I estimated in my original value.  In the sections below, I hope to stress test these assumptions, more as a friendly observer than antagonist.

Market Breakthrough

Companies like Amazon, Google and Netflix owe their success and immense market values to their capacities to redefine markets (retail, advertising and entertainment respectively) and it is true that in these and other cases, investors and analysts have under estimated these capacities and have paid a price for doing so. Unfortunately, it is also true that there have just been many cases where managers and investors have over estimated the capacity to expand markets and lost money in the process.  The Gurley narrative for Uber makes a good case that the convenience and economics of Uber will expand the car service market initially to include light users and non-users (suburban users, rental car users, aged parents and young children), but it does have three key barriers it has to overcome:

1. Reason to switch: Uber has to provide users with good reasons to switch from their existing services to Uber. For taxi services, the benefits from using Uber are documented well in the Gurley narrative. Uber is more convenient (an app click away), more dependable, often safer (because of the payment system) and sometimes cheaper than taxi service. However, the trade off gets murkier as you look past taxi services. Since mass transit will continue to be cheaper than Uber, it is comfort and convenience that will be the reasons for switching. With car rentals, Uber may be cheaper and more convenient in some senses (you don't have to worry about picking up a rental car, parking it or worrying about it breaking down) and less convenient in others (especially if you have multiple short trips to make). With suburban car service (the aged parents, the dating couple and school bound kids), the problem that Uber may face is that a car is usually more than just a transportation device. Any parent who has driven his or her kids to school will attest that in addition to being a driver, he or she has to play the roles of personal assistant, private investigator, therapist and mind reader. As for date nights, whether Uber succeeds will be largely a function of how much the car itself is an integral part of the date, especially with younger couples.
2. Overcome inertia: Even when a new way of doing things offers significant benefits, it is difficult to overcome the unwillingness of human beings to change the way they act, with that inertia increasing with how set they are in their ways. It should come as little surprise that Uber has been most successful with young people, not yet set in their ways, and that it has been slower to make inroads with older users. That inertia will be an even stronger force to overcome, as you move beyond the car service market. The articles that point to young people owning fewer cars are indicative of larger changes in society, but I am not sure that they can be taken as an indication of a sea change in car ownership behavior. After all, there have been almost as many articles on how many young people are moving back in with their parents, and both phenomena may be the results of a more difficult economic environment for young people, who come out of college with massive student loans and few job prospects.
3. Fight off the status quo: The empire, hobbled and inefficient though it may be, will fight back, since there are significant economic interests at stake. As both Uber and Lyft have discovered, taxi service providers can use regulations and other restrictions to impede the new entrants into their businesses. Those fights will get more intense as car rental and car ownership businesses get targeted.

In summary then, the difference in market size in the narratives boils down to a simple calculus of what is probable, what is plausible and what is possible, a distinction that to me is at the center of value:

Not everything that is possible is plausible, and not all plausible opportunities make the transition to the probable.  As I see it, the divergence between the my narrative and Bill Gurley's are captured in where we draw the lines between the probable and the plausible and the value that we attach to the possible. At the risk of mischaracterizing Mr. Gurley's thoughts, I have tried to contrast these differences:

Here again, Bill Gurley has two advantages to work with. The first is that as an investor and insider, he has access to information on Uber's experiences and experiments in its frontier markets (mass transit and suburban users), that may have led him to shift these markets from the plausible to the probable. The second is that as a board director and advisor to management, he is in a position to influence Uber's potential in these markets. For all we know, the Uber Momcar and the Uber Datecar have been already conceived, market tested and are ready to go.

I think Bill Gurley and I agree on the car ownership market  more than we disagree. I see it as a possibility right now and attach an option value of about $2-3 billion to it, partly because it is in the more distant future and partly because Uber's business model in this market is unformed. From Bill Gurley's description of the market, I think he sees it as a possibility as well, though I think he attaches a larger value to it than I do. The reason for the higher value is that it is a conditional possibility, with the likelihood of it happening increasing with the success that Uber has in the car service market. 

Network Benefits

The second part of the Gurley Uber narrative rests on the company having network benefits that allow it to capture a dominant market share. As Mr. Gurley notes, a networking effect shows up any time you, as a user of a product or service, benefit from other people using the same product and service. If the networking effect is strong enough, it can lead to a dominant market share for the company that creates it and potentially to a  ‘winner take all’ scenario. The arguments presented in his post for the networking effects, i.e., pick up times, coverage density and utilization, all seem to me to be point more to a local networking effect rather than a global networking one. In other words, I can see why the largest car service provider in New York may be able to leverage these advantages to get a dominant market share in New York, but these advantages will not be of much use in Miami. There are global networking advantages listed, such as stored data that can be accessed by users in a new city and partnerships with credit car, smartphone and car companies, but they seem much weaker.

In fact, if the local networking advantages dominate, this market could very quickly devolve into a city-by-city trench warfare among the different players, with different winners in different markets. Thus, it is possible that Uber becomes the dominant car service company in San Francisco, Lyft in Chicago and a yet-to-be-created company has the largest market share in London.  For the Gurley Uber narrative to hold, the global networking advantages have to become front and center and here again, it is possible that I am unaware of a management initiative designed to do exactly this. 

The Verdict Awaits

I know that this may be hard to believe but I have less of an interest in making the case that Uber is over priced than I am in understanding what it is that drives its value. I have learned a great deal about why Bill Gurley is so excited about the company but I am inherently cautious, not because I don’t find his arguments to be plausible, but because I have seen how often the plausible does not make the transition to the probable and how frequently the probable fails to show up in the actuals. That quality may make me a bad venture capitalist but I am sure that there are plenty of good ones out there to take up the slack.