The true valuation of internet companies?

The internet companies like Google and Amazon are held up as totemic examples of innovation in our times. They have enormous valuations and their founders are held on a pedestal.  

But really how innovative are they? How do we place their productivity in perspective?

The underlying idea behind all these firms are a few - social connections, two-sided marketplace, aggregating demand, search engines, digital content streaming etc. These are economic opportunities that naturally opened up when the current generation of new technologies - very fast internet, smartphones, and cloud storage - become available cheaply. In such times, it is only natural that many entrepreneurs compete to bring out products and solutions that can seize these opportunities. Among all of them, and located in the most productive and competitive global market, some will emerge successful. Among them, the differentiator is most often plain good luck. In such new industries, these companies invariably benefit from their first-mover advantage.

It is equally true of railroads, automobiles, telecommunications and so on. Take the example of the evolution of the automobile industry. Its initial decades of innovation spawned the car, bus, truck, and so on. And in each of these types there was further differentiation. Today we take them for granted. 

In all these cases, the first movers benefited. However, in case of the tech companies, while some have brought out hitherto unavailable products, others are basically cannibalising existing markets. In fact, one can list out atleast five channels that the incumbent internet companies benefit from:

1. Regulatory arbitrage - the benefit of being able to externalise costs and appropriate benefits from being a publisher and employer compared to their brick-and-mortar competitors.

2. Regulatory lags - the benefit of being in a new and rapidly changing industry, where regulatory standards or areas like data protection and privacy are lagging behind in evolution

3. The data ownership effect - the benefit of being able to appropriate their user's data and digital trails for private benefit without paying for those users.

4. The network effect - the benefit of being at the centre of a large organically-evolving eco-system, where increasing numbers of users increase the value of the service offered by the company.

5. The large company effect - the benefit of a large company being able to deploy more resources and undertake more R&D, as well as having access to more and diverse data which in turn helps refine the business.

The first three provide the profitability (or subsidy) boost by keeping costs lower than would be required in a mature future state of the market, and last two erect barriers to entry and competition and therefore provide the pricing power. Restrictions on the first three are perhaps inevitable and only round the corner. On competition grounds too pressure has been mounting to break-up large internet companies. With large company effects, they will gradually taper off and there will be the costs of needing to incorporate elements of resilience.

A sixth factor is the resilience discount that benefit first-movers. Covid 19 has exposed the vulnerabilities of even the largest of such companies in this regard. Amazon's problems in its inventory and logistics management as well as the e-marketplace distortions is now well known. Equally well-known are the numerous human resource management problems in its fulfilment centres. We were already aware of the data protection and privacy related challenges with the likes of Facebook.

The likes of Amazon have been riding three waves of linear growth. One, emerging technologies provide the opportunity for improving business processes. Two, the new nature of the business activity provides the market growth runway. Three, good economic times provide the business growth momentum.

It creates business models which elevate efficiency, and especially that driven by cost minimisation, as the predominant only operating principle, at the marginalisation of other factors like resilience, safety, workers rights, fairness, and so on.

It is far easier to sustain turbocharged growth in a new business activity in good economic times in a very large global market. Driving efficiency gains can be a comfortable linear process, a technical challenge, especially when there are limited regulatory standards and oversight and impenetrable entry barriers. The real challenge is to survive multiple downturns and shocks, pass layers of regulatory requirements, and competition from others without entry-barriers to become a resilient company. This adds layers of new costs, episodes of one step-forward and two-steps backward, and the relegation of technical side of the business to the backseat as market competition and regulatory challenges loom large. 

Resilient systems demand sufficient slack. They often conflict/trade-off with brute force automation-driven efficiency. This slack manifests in multiple ways - efficiency wages for workers, redundancies in equipment, cushions with personnel management, flexibility with adaptation that goes beyond just the technology kind, more than just-in-time inventories and storage space, and so on. The e-commerce models of the likes of Amazon are way behind on these.  

Underlining this dynamic of the need to absorb additional costs, while Amazon's revenues have risen post-Covid, its costs have soared even faster.

But coronavirus-driven wage increases — which have already cost an additional $700m, up from an initial estimate of $350m — are just one factor that could see the company’s costs spiral throughout the year. “We’re looking at $1.5bn extra each quarter,” said Scott Mushkin, chief executive of R5 Capital, which is so far the only big Wall Street analyst to give Amazon a “sell” rating ahead of Thursday’s filing. “It’s not that we don’t think Amazon’s going to gain share, [that] we don’t think it’s going to grow — we just think it’s going to grow more slowly.”... In addition to new personnel, Amazon has needed to install new equipment, such as thermal cameras, at warehouses to monitor staff health more quickly. Previously, it was using handheld thermometers.

Similarly, take the example of Netflix. Look at the risks,

Netflix acknowledges that subscriptions may simply have been accelerated by lockdown. If so, they may slow again when restrictions are eased. Cash burn could then tick up. The company needs money to bankroll new content but has yet to lay to rest a long-standing concern that its rising international revenues will not offset slowing subscriber growth in America, its biggest market. In the first quarter its foreign revenues were crushed by the surging dollar. At the same time Netflix faces new competition, both at home and abroad. Disney+, launched last November, has attracted 50m subscribers globally... Look beyond covid-19 and the worry is not just that Netflix subscribers will flee to other streamers. It is that as other big media companies shift to streaming, they will refuse to sell it new shows (as Disney has done as it launched Disney+) or license it old stuff (as happened this year with “Friends”, bought by WarnerMedia in 2019). That would force Netflix to spend ever more to keep up.

Clearly the markets discount all these risks to value Netflix higher than even Disney which has all its physical and other content production service collateral. All this is not even taking into account that China will remain a difficult market to crack, and India too will have its T-Serieses and Jios. But what about its valuation?

Its market value, at more than $190bn, has for the time being risen above Disney’s... junk-rated Netflix now borrows at similar interest rates to a-rated Disney.

As Aswath Damodaran has written, in such cases, we are talking about pricing (what everyone in the market thinks is price to buy into the company) and not valuation.

This also raises the question of whether the valuations of all internet companies should be imposed a resilience discount. 

It will be useful to have a study which tries to quantify the contributions of each of these six effects on the internet companies. What are the contributions of each of these to the valuation of today's internet superstar companies? Strip them out and what is the true innate value addition?

A discounted valuation based on these six factors would perhaps be a truer measure of the underlying future prospects of such companies than one which assumes all these drivers to remain active forever.