WARNING: This long-winded author lacks objectivity and uses high pressure tactics to sell his vision of Yahoo! Not only is he a known long, but he is also down about 70 % in the stock. If you are a consenting adult and you choose to read this post, please take it with two or more grains of salt. Trust only your own due diligence.
Re: Network Effects, Yahoo, and Valuation
Yesterday the thread returned to the eternal investor's questions: How do I select a company that will have sustainable growth? How do I know when the price of the stock is less than the value of its future cash flows?
And, the thead did so from the perspective of the merits or demerits of the idea of "network effects," given the thread's commitment to Gorilla investing.
Michael Mauboussin's paper, "Network to Networth" was recommended as a useful source for learning about network effects. Mauboussin believes that, if the market is moderately efficient, then the wisdom of the market has decided that dot.com stocks possess some underlying value. Like Moore, the issue becomes for Mauboussin which dot.com stocks specifically have value and which reflect mere enthusiasm for the hot-stock-of-the-day.
Both Moore and Mauboussin agree that they search for stocks with sustainable competitive advantage. In doing so they acknowledge that elements in Porter's model of competitive advantage remain valid today. Moore's answer to the questions of how to find a company with sustainable competitive advantage among the high technology product companies is the set of criteria that identify a gorilla. The Gorilla Game identified those criteria as part of its taxonomic model. For Moore, a more basic model is the Technology Adoption Life Cycle that he had previously used in In the Tornado and Crossing the Chasm. This model is an amendment and extension of Everett Rogers's model of the diffusion of innovations.
Rogers saw the diffusion of innovation as "the process by which an innovation is communicated through certain channels over time among the members of a social system." Rogers introduced the S-curve of cumulative adoption and categories of adopters among his many contributions. (Many such definitions are included in post # 32422.)
In post #29114, I explored Moore's model of the gorilla game by examining his basic models, indicating that he was following a build-test-observe model, using a feedback loop that is so characteristic of social science. In post, #29340, I examined how Moore had tied the elusive concept of "power" to Porter's "competitive advantage," and how Moore stressed the importance of catching the technology wave as primary in his model of hierarchical competitive advantage in Fault Line. He said the Internet offered a 100X advantage.
In post # 25759, I explored Mauboussin's "Why Strategy Matters" which interrelates strategy as generic with competitive advantage as tactically specific. Mauboussin noted that competitive advantage is a quantitative issue; it exists when a company's sales are greater than its total costs, using ROIC-WACC spreads. In "On the Shoulders of Giants," Mauboussin and Hiler described three macro features of the new economy: (1) the economics of networks, which includes the concept of network effects, (2) the dramatic reduction in transaction costs, and (3) the central role of knowledge. Mauboussin identified seven main mechanisms in new economy companies: (1) high upfront costs, (2) first-mover advantage, (3) path dependence, (4) tipping points, (5) network effect, (6) positive feedback, and (7) lock-in.
In post # 30596, I pointed out that Mauboussin begins with the premise that that value of a stock, and hence, stock price, is the expected net present value of a future stream of free cash flows. For Mauboussin, the true economic drivers of value are free cash flow, risk, and the competitive advantage period. Mauboussin combined these ideas, which are derived from the Shareholder Value approach of Alfred Rapapport, with ideas about complex adaptive systems derived from the Santa Fe Institute.
Readers familiar with Moore's GAP and CAP will notice the overlap here. If not, in post #31379, on the exponential power of network effects, I discussed the overriding importance of sustainable competitive advantage, concluding with, "sustainable competitive advantage is the key concept in qualitative stock analysis, and its tight linkage to the value-added economic model insures that sustainable competitive advantage, in actuality, does drive shareholder value." In post # 31380, I examined fifteen exploitable gaps in expectations as tips for practical investing after summarizing Mauboussin's contributions to understanding network effects, including Rogers's and Moore's contributions. One paragraph that I wrote is worth quoting:
"Because the concept of "network effects" is nested in Moore's fundamental and integrated models, at home in the Value-Based Economic Model and the model of the Technology Life Cycle, some gorilla gamers may want to consider the argument that network effects produce a sustainable competitive advantage. Any network effect that achieves critical mass becomes locked-in while it simultaneously creates high switching costs. Achieving a critical mass is described alternatively as reaching the tipping point, or the inflection point in the elbow of the S-curve, or entering hypergrowth after crossing the chasm. The assessment of the relative investment risk of lock-in that is achieved by a proprietary open architecture or by network effects that have achieved critical mass is complex. Caution urges the risk-averse to side with the gorilla; whereas, the temptation of increased excess returns urges the risk-embracing to side with the light business models of large, expanding networks. Each investor must make his/her own choices."
In response to my post #32503, in which I suggested that it might be best to examine a prototypical network company, such as "the shockingly alien" Yahoo, as the first case study in our exploration of network effects, Mike Buckley in post 32506, replied, "If you're willing to be the first one up to bat, I think that's a marvelous idea." So, I did my best in posts #33891, 33893, 33904, and 33896.
Regardless of the shortcomings in my report on Yahoo, it is important not to throw out some of the "ideas" along with the "author." Certainly, Y!'s light business model and financial metrics are exceptional using any known objective standard. Not only that, Elizabeth Demers and Baruch Lev's research on the Internet shakeout of 2000 is important. It demonstrates that web metrics for REACH and STICKINESS were significantly positively correlated with Price/Sales ratio, their index of stock value, in both 1999 and 2000.
Although I did not emphasize it, and I should have, Lev believes this demonstrates that web metrics are drivers of stock value. Here, a "driver" means that he believes he has established a causal linkage. Perhaps, because I believe his standards are too low here, I failed to make this point. However, his data are suggestive that web metrics can serve, not only as leading indicators, but also may serve as a proxy or, in fact, is a driver of stock price. To my knowledge, this is the first evidence that network effects can be measured by web metrics and that they play a causal role in driving stock price. Also, important in this context is the information that Jeff Mallet offered in the Q3 CC that registered users account for much of the value within the other web metrics. Registered users epitomize interactivity, the driver of strong network effects. This empirical evidence from Lev and Mallet supports the model of network effects.
Although I won't review the advertising issues here, you may want to read the latest issue of Fortune, which offers another very favorable review of Y!'s use of targeted advertising for top companies.
However, I do want to give you another look at the issue of valuation using Y! as an example. Poster dond411 (this is not me), on the TMF l'union fait la force thread offered a new valuation model on 12/5. He suggested a valuation ratio that divides price per sale by 5-year compounded growth rate that is next multiplied by the flow ratio divided by ROIC - WACC. To adjust the majority of numbers from fractions to integers, he suggested multiplying the resulting totals by 10. He reported numbers for 14 leading companies, including CSCO and NTAP, to illustrate his approach. He offered the rule of thumb that any stock with a valuation ratio under 2.00 is undervalued. It probably won't surprise you, given my known penchant for high-pressure sales tactics, to find that Yahoo offers the best value in his sample, with a value ratio of 0.27.
boards.fool.com
Within the next two weeks, I will try to post a report on network effects in the gorilla candidate, Wind River, to illustrate how network effects might illuminate or add to some aspects of the gorilla criteria. |
