Curated Insights 2018.07.20

Professor Aswath Damodaran on valuation

The most egregious valuation mistake that I see investment professionals make is mistaking pricing for valuation. Most investment professionals don’t do valuation, they do pricing. What I mean by that is that you price a number to a stock based on what other people are paying for similar stocks. Any time you use a multiple comparable you’re not valuing the company, you’re pricing a company. Ninety percent of the time, when someone says “I’ve valued a company at X”, I always have to stop and ask them, “What do you mean value the company?”. Most of the time when I extract the answer, the answer is that they’ve really priced the company. There’s nothing wrong with pricing. But it’s not valuation. Valuation is about digging through a business, understanding the business, understanding its cash flows, growth, and risk, and then trying to attach a number to a business based on its value as a business. Most people don’t do that. It’s not their job. They price companies. So the biggest mistake in valuation is mistaking pricing for valuation.

The biggest mistake is that VCs don’t value users, they price them. What I mean by that is that if there’s a line of VCs and you go up to a VC and say “I have a million users”, the VC says “Amazing, I’ll pay you $1 Billion”. Most VC’s are still pricing users, with the assumption that all users have value, and that all their data is going to be useful. And I think that’s a dangerous thing. The reason I wrote that paper is to illustrate that users can be valuable, but users can be useless. Moviepass users are useless – there are a lot of them, but I don’t think the marginal Moviepass user adds any value. In fact, I think that they destroy value, because you’re giving them a service for way below cost. Netflix users, are clearly much more valuable as a commodity. I think that we have to differentiate between users, and to do that we have to start asking serious questions about what separates good users from bad users, what separates valuable users from useless users.

Well it’s massively impacted prices. It’s going to mean that there’s going to be a lot more splitting up of the market, like with Uber and Didi in China, and with Uber and Grab’s agreement in Southeast Asia. I think increasingly that the ridesharing companies think that the future lies in each of them carving out markets for themselves where they don’t face competition. Softbank incentivizes that by being invested in all of these companies. Uber, Lyft, and Grab fares will start to go up, and you can thank Softbank for that. They’re the ones in the background impacting how this business is evolving.

It’s a feature not a bug. It’s the nature of young companies and young markets, that you will overvalue them, because you’re looking at clusters of what I call overoptimism. Each cluster, be it the VCs and employees of a company think that they have the answers to the big questions. It’s how markets evolve, and I think that it’s a healthy process. I think that bubbles are not always bad, because they’re what allow us to change and move on. So I think that you can look at bubbles as a bad thing and try to make them go away, but I think that they’re a good feature of markets and allow us to shift from one business to another, from one technology to another.


How internet advertising can grow to $600 billion by 2023

While digital direct response advertising took share from print in the first leg of internet, digital video advertising could take share from TV in the second leg. What would be the impact on budgets of sustained strong growth in internet advertising? If you assume compounded growth rates of 15% for Google, 20% for Facebook, 20% for China, and 12% for everyone else, internet advertising would reach $620 billion by 2023—a figure that’s larger than the entire global advertising market today.

One might say that that is sufficient proof that internet advertising must slow down less it exceeds its total addressable market. But it’s just as dangerous to assume that the size of advertising market is a static number or a fixed percent of global GDP.

Amazon in particular has potential to contribute out-sized growth. Already roughly half of US consumers start their product search on Amazon, bypassing Google’s most important search ads. These shoppers see Amazon’s sponsored product ads which are highly valuable and result in direct measurement of sales. Amazon’s $3 billion ad business is growing quickly and could dampen Google’s search business in the coming years.

Analysts and investors have historically underestimated the size of the internet advertising market and continue to do so based on a static set of assumptions. Yet, more than any other medium, internet advertising has evolved and re-invented itself constantly. The drivers of growth today – mobile, video, and programmatic – barely existed ten years ago. There’s no telling what the next ten years might bring.


Texas to pass Iraq and Iran as world’s No. 3 oil powerhouse

Texas is pumping so much oil that it will surpass OPEC members Iran and Iraq next year, HSBC predicted in a recent report. If it were a country, Texas would be the world’s No. 3 oil producer, behind only Russia and Saudi Arabia, the investment bank said.

The combined output of the Permian and Eagle Ford is expected to rise from just 2.5 million barrels per day in 2014 to 5.6 million barrels per day in 2019, according to HSBC. That means Texas will account for more than half of America’s total oil production. By comparison, Iraq’s daily production is seen at about 4.8 million barrels, while Iran is projected to pump 3 million. Oil supplies from Iran are likely to plunge due to tough sanctions from the United States.


Beijing did a tech reality check on its industrial champions. The results were not amazing

The ministry questioned the companies about 130 “core components and materials”, finding them reliant on imports for 95 per cent of central processing unit and CPU-related chips for their computers and servers. The companies also depended on foreign suppliers for 95 per cent of the advanced manufacturing and testing components on production lines for various sectors, including rockets, large aircraft and even cars, according to the report published on Friday. About a third of the “key materials” covered by the survey were not available in China, the state news agency reported, without detailing the items covered or when the survey was conducted.

Google fined a record $5 billion by the EU for Android antitrust violations

While many had expected Google to face its own “Microsoft moment,” the EU doesn’t seem to be forcing any strong future oversight on Android or asking Google to modify its software to include a ballot for alternative browsers or search engines.

This decision seems to be more about preventing Google from bundling its services to Android, than forcing the company to change Android significantly. Phone manufacturers will still be free to bundle Chrome and Google search apps if they wish, but they won’t be forced to do so, and they’ll be free to offer devices with forked versions of Android.

Amazon’s share of the US e-commerce market is now 49%, or 5% of all retail spend

The figures are also remarkable not because of their size, but because of Amazon’s pace has not slowed down. Its sales are up 29.2 percent versus a year ago, when it commanded 43 percent of all e-commerce retail sales.

The rocket ship for Amazon’s growth at the moment is its Marketplace — the platform where Amazon allows third-party sellers to use its retail and (if they choose) logistics infrastructure to sell and deliver items to Amazon shoppers. It’s currently accounting for 68 percent of all retail sales, working out to nearly $176 billion, versus 32 percent for Amazon’s direct sales, and eMarketer projects that by the end of this year, Marketplace’s share will be more than double that of Amazon’s own sales (it’s already about double).


Amazon set for Prime Day ad revenue bonanza

The need to advertise to cut through the crowd on Prime Day underscores the growing contribution of advertising to Amazon’s business. While its Amazon’s core retail operations generate the majority of its revenue, executives and analysts see advertising as a promising growth area. Its “other” revenue segment, mostly derived from advertising, more than doubled to $2bn in the first quarter and the company flagged the high-margin business as “a strong contributor to profitability”.

Amazon’s slice of the $100bn US digital ad market is still very small: 2.7 per cent, or fifth place, this year compared with Google’s 37.2 per cent and Facebook’s 19.6 per cent, according to eMarketer. Its share is expected to reach 4.5 per cent by 2020, passing Microsoft and Verizon’s Oath to climb to third place, while Google and Facebook are predicted to lose ground.


Mark Mahaney, analyst at RBC Capital Markets, estimates that by 2022 Amazon’s ad revenues will top $25bn and generate more than $8bn in incremental operating profit, making the business “as impactful” to the company as Amazon Web Services, its cloud computing business, is today.

Travel giant Booking invests $500M in Chinese ride-hailing firm Didi Chuxing

Besides Booking.com and Agoda, Booking also operates Kayak, Priceline.com, Rentacars.com and OpenTable, all of which makes it a powerful ally for Didi. That’s particularly important since the Chinese firm is in global expansion mode, having launched services in Mexico, Australia and Taiwan this year. Beyond those three, it acquired local ride-hailing company 99 in Brazil and announced plans to roll into Japan.

Beyond boosting a brand and consumer touchpoints, linking up with travel companies makes sense as ride-hailing goes from simply ride-hailing to become a de facto platform for travel between both longer haul (flights) and short distance (public transport) trips. That explains why Didi has doubled down on dock-less bikes and other transportation modes.

Reuters reports that the unit, which was formed in April and consists of Didi’s car rental, sales, maintenance, sharing and gas services businesses, could be spun out in a deal worth $1.5 billion. The thinking is apparently that Didi’s IPO, which is said to be in the planning stages, would run smoother without these asset-heavy businesses involved.


Spotify’s new tool helps artists and labels reach its playlist editors

The company says that, today, more than 75,000 artists are featured on its editorial playlists every week, plus another 150,000 on its flagship playlist, Discover Weekly.

These days, artists and labels ask for intros to playlists editors, believing that getting to the right person will give them an edge in having their tracks selected for a playlist. The new submissions feature aims to change this process, while also driving artists and labels to use Spotify’s own software for managing profiles and tracking their stats on the service.

We want to make something crystal clear: no one can pay to be added to one of Spotify’s editorial playlists. Our editors pick tracks with listeners in mind. They make these decisions using data about what’s resonating most with their community of listeners.

What are cobots? Understanding the newest wave of smart robot reinventing whole industries

Now, incumbents are playing catch-up against Teradyne’s cobot division Universal Robots (UR), which currently claims around 60% of the cobot marketshare. Big names like ABB, Fanuc, Yaskawa, KUKA, and Robert Bosch, which are all better known for their low-tech robots, have followed UR into the cobot market. (It’s estimated that Fanuc has between 6% and 10% of cobot market share, and Yaskawa’s is even smaller.) And partnerships are springing up: Kawasaki is now working with its Swiss rival ABB to standardize robotic programming.

One big reason could be labor costs rising worldwide. Because of economic growth, wages in industrialized countries have soared. In China, for example, average wages have more than doubled since 2006, and the country is no longer considered a destination for low-cost outsourcing. In fact, China is now so expensive that it’s losing consumer electronics jobs to lower-cost neighbors like Vietnam, pushing its robot demand to grow more than 20% just last year.

Expensive labor is also tilting the scale for more localized manufacturing, and robotics are enabling a new wave of re-shoring (the return of manufacturing to the United States). In a 2015 survey by BCG, 20% of US-based manufacturers surveyed said they were actively shifting production back to the US from China, or were planning to do so over the next two years. The majority said lower automation costs have made the US more competitive.

Subsequently, firms are increasingly turning to cobots, which these days are easily programmable, cheaper than traditional labor, and even inexpensive compared to “dumb” robots. For all of these reasons, cobot makers are selling more units at lower prices than ever before.

How has the average US house size changed?

Over the past 95 years, average [residential home] floor area has increased from 1048 square feet to 2657 square feet, which equates to a 2.5x increase. Furthermore, the average floor area per person has more than quadrupled, from 242 square feet to 1046! Essentially, it’s likely that one person nowadays has the same amount of space as a family back in the 1920s.

Curated Insights 2017.09.24

Ferrari bets racetrack wins will lead to showroom sales

Ferrari’s financial success over the past 15 years has “been achieved on the back of Formula One,” the CEO said in March, adding that the company couldn’t afford many more losing seasons without suffering financially.

But there is little empirical evidence that winning races translates into increased sales. AllianceBernstein, a wealth manager, argues Ferrari doesn’t need Formula One. “There can’t be a soul on earth who doesn’t know that Ferrari makes fast red cars, with excellent technology and that it has a motor sport heritage,” AllianceBernstein wrote in a report last month, adding that Lamborghini, Porsche and other high-end brands have no trouble selling cars despite being absent from Formula One for many years.

While Ferrari doesn’t reveal its estimates for the financial and promotional benefits it derives from Formula One, Mercedes said that in 2016 it got the equivalent of $3 billion in advertising value from the team.

For years, the company limited its sales to no more than 7,000 cars annually to stoke demand. Now, Mr. Marchionne plans to raise that limit to 10,000 in the coming years, while also moving Ferrari into new areas such as home furnishings and technology products.


Liu Qiangdong, the ‘Jeff Bezos of China’, on making billions with JD.com

It was just three years ago that China overtook the US as the largest e-commerce market — but last year China’s total online retail transactions hit an estimated $750bn, nearly double the figure in the US. Most analysts predict China’s online retail market will more than double again by 2020, by which time Chinese online purchases are expected to exceed those of the US, UK, France, Germany and Japan combined.

The contradiction between Alibaba’s much larger market share and profits but smaller revenues is explained by the rivals’ different business models. Like Amazon, JD.com controls most of the supply chain and delivers goods from its own warehouses directly to customers, so it counts online sales as revenues. Alibaba, by contrast, is essentially an internet platform and payment system for other companies and individuals selling to consumers online and earns the bulk of its revenue from advertising.

“I was the first and only stall in that market to put price labels on everything and give official receipts; from day one I never sold any counterfeits and I soon had the best reputation,” he says. “A lot of rich people in China cannot sleep well because they did too many wrong things but I never made any dirty money ever so I can sleep very well.”

What’s the true TAM of search?

To truly appreciate the nature of information distribution, we need to think in a broader context and challenge some assumptions: what if “online advertising”, or even “advertising” is not the right way to measure the TAM (total addressable market) for the search engine business?

If we correctly define the role of search engines, we can see that what they are really designed to address is actually something much broader – “search cost”. Search cost is the biggest component of what economists label as “friction cost” in an economy and it can exist and be addressed in many different forms.

All of that excess rent is a form of marketing that brands and retailers pay to address “search cost”. In a purely online environment, the physical location is disintermediated and what companies would otherwise pay in excess rent in an offline setting would presumably get re-allocated in the form of Amazon commissions or Google keyword ads.

Actually, most of the time, new technological developments have a tendency to shrink the TAM as technology is usually deflationary (the search engine being an exception), so be careful when you see IR slides of tech companies where management takes an estimate of the market size today and declares that number as their company’s financial destiny – it most likely overstates the actual TAM.


Google Travel is worth $100 billion — even more than Priceline

Our estimate of $11.2 billion in Google travel revenue in 2016 would mean that travel accounted for 13 percent of Google’s total Google Segment revenue and 12 percent of the company total (includes the so-called other bets part of the business). Google’s total Google segment operating margin is in the low 30s, but the core AdWords business is likely much higher (meta would likely be in the 25 percent range).

Given a margin profile that is likely above Priceline and digital ad spend growing more than 20 percent per year, the value of the travel business would warrant a similar price-to-sales multiple as Priceline; off of 2016 results, Priceline trades at over 8x revenue. As mentioned earlier, using a 7x multiple on our estimated 2017 numbers for Google, the Google travel business could be worth as much as $100 billion or 15 percent of Google’s $650 billion market cap.

Online travel companies would like to diversify away from Google, but no other digital marketing tool offers the same commercial intent of a Google search.


Gaming sector primer

The gaming sector is the most attractive industry I see today due to: relative low price point and inelasticity; highly addictive products; cyclical defensive; ability for some to capture consumer surplus; consistent high margins and ROE. The downsides are: difficulty in developing new IP; high rate of reinvestment.

Imagine being able to sell $5 worth of coca cola to someone and $5000 worth to someone else, suddenly the need to build a massive horizontal distribution platform is terribly wasteful and your efforts are better spent capturing a smaller share of premium clients, which is made possible by the internet and ubiquitous mobile phones.

Today the gaming sector in China is dominated by mobile due to the ubiquitous nature of phones compared to the lack of platform penetration of console and to a lesser extent PC games. As a result, the two Chinese companies which dominate the gaming space, Tencent and Netease, which together control arond 80% market share, were able to leapfrog the traditional console/pc game market and focus largely on mobile and are in my opinion global leaders at the art of capturing consumer surpluses.


The death of (many) brands

Companies with a trusted brand could earn excess economic returns so long as the cost of building the brand costs less than the premium consumers were willing to pay for a product due to the brand. Because brands have historically be very durable (notice the global brands that were built in the 1950 are still dominate today), they created an economic moat that caused these companies to generate outstanding returns for shareholders.

Costco leverages their scale to identify high quality, good value products and deliver them to consumers. This process reduces the value of brands and allows Costco customers to confidently buy non-brand products or products with limited brand recognition. In this way, Costco has managed to earn excess economic returns, even while selling the products in their stores at close to cost.

Now, however, the era of search cost brands is coming to an end. The moats are being breached. Over the long term, we do not believe that these types of brands will provide a significant competitive advantage to their owners and the companies will be forced to compete directly on quality and value instead of earning a return for selling reduced search costs.


China’s electric car push lures global auto giants, despite risks

From high-speed trains to wind turbines, China has long prodded American, European and Japanese companies to hand over their know-how in exchange for access to its exciting new market. Then Chinese companies have used that knowledge and lavish government support to take on foreign rivals. China wants the big players to share their electric car knowledge, too. The foreign automakers face new Chinese regulations that put heavy legal pressure on them to transfer electric-car technology to their local partners.

The joint ventures alone may not make China a leader in electric cars. G.M., Volkswagen and other major automakers have made regular cars with Chinese partners for decades, and China had hoped its automakers would learn how to make their own worldbeating brands. Instead, Chinese automakers grew comfortable making Chevrolets and Volkswagens for local drivers. Only recently have foreign automakers begun exporting Chinese-made cars to buyers back home.

More broadly, global automakers feel that they must grow in a country that has become the world’s largest car market, one almost as big as the American and European markets combined.


Materialize.X is using machine learning to disrupt the $300B engineered wood industry

A lot of engineered wood is created using an adhesive called urea-formaldehyde, which has recently been labeled by the FDA as a toxic carcinogen…The startup has created a patented non-toxic adhesive to serve as an alternative to urea-formaldehyde. Materialize.X plans to license to chemical companies, or engineered-wood manufacturers so they can make the adhesive on site, the method for making this adhesive.

…created software that uses machine learning to take in all those variables and make slight changes to the manufacturing process that can greatly improve the quality of the final product. Examples of these changes are adjusting the amount of adhesive used or increasing the pressure in the bonding process depending on the variables listed above.


The new Texas gold rush: Buying sand for fracking

Texas energy producers have typically bought the millions of pounds of sand that each well requires from mines located far from their drilling fields. After oil prices collapsed in late 2014, though, cost-conscious drillers reconsidered their well designs and recipes for the slurries they blast underground to unleash fuel from shale formations. Many West Texas drillers discovered that they could replace sand they had been shipping from mines 1,300 miles away in Wisconsin with finer grades found in dunes nearby. Doing so eliminates rail costs that sometimes are equal to or more than the sand itself.

The prospect of tens of millions of tons of Permian sand coming to market could drive down sand prices that have been rising nationally, Mr. Handler said. Analysts say that prices rose to as much as $45 a ton earlier in the year, from as little as $15 a ton last year.

Hedge-fund manager Daniel Loeb is among those betting that sand stocks will fall further. In an April letter to his Third Point LLC investors, Mr. Loeb cited the “important shift” from special sand mined in the Midwest to abundant sand within drilling basins, including West Texas.

Superpower India to replace China as growth engine

The number of people aged 65 and over in Asia will climb from 365 million today to more than half a billion in 2027, accounting for 60 percent of that age group globally by 2030, Deloitte said in a report Monday. In contrast, India will drive the third great wave of Asia’s growth – following Japan and China — with a potential workforce set to climb from 885 million to 1.08 billion people in the next 20 years and hold above that for half a century.

“India will account for more than half of the increase in Asia’s workforce in the coming decade, but this isn’t just a story of more workers: these new workers will be much better trained and educated than the existing Indian workforce,” said Anis Chakravarty, economist at Deloitte India. “There will be rising economic potential coming alongside that, thanks to an increased share of women in the workforce, as well as an increased ability and interest in working for longer. The consequences for businesses are huge.”


Why machine learning funds fail

The complexities involved in developing a true investment strategy are overwhelming. Even if the firm provides you with shared services in those areas, you are like a worker at a BMW factory who has been asked to build the entire car alone, by using all the workshops around you. It takes almost as much effort to produce one true investment strategy as to produce a hundred. Every successful quantitative firm I am aware of applies the meta-strategy paradigm. Your firm must set up a research factory where tasks of the assembly line are clearly divided into subtasks, where quality is independently measured and monitored for each subtask, where the role of each quant is to specialize in a particular subtask, to become the best there is at it, while having a holistic view of the entire process.


The case for & against cryptocurrencies (for those tired of all the noise)

The strongest cases for the existence of cryptocurrencies in my mind include: (1) allowing for a decentralized Internet in which value is accrued to infrastructure, protocols and applications that serve market needs; (2) allowing electronic trade across actors who may not know or trust each other without middlemen who take a heavy toll / tax on the transaction; (3) allowing for (the potential of) a more stable currency than one’s own government for citizens who may live under despotic or irresponsible regimes.

The simple case against cryptocurrencies includes three completely related factors: (1) powerful governments who won’t tolerate the loss of monetary control or illegal activities; (2) societal pressure to regulate cryptocurrency will increase as more people are duped, as more fraud is discovered, as more hacks occur and as more market participants collaborate to manipulate the value of the currencies themselves; (3) erosion of trust as first-time cryptocurrency participants get duped, lose money and develop skepticism for the asset.

There is a fascinating story in “The Ascent of Money” by Niall Ferguson in which Ferguson describes how the modern corporation emerged. About 400 years ago merchants from the Netherlands were sending ships to Asia in search of spices widely desired in Europe. More than 50% of all ships that sailed wouldn’t return so groups of people banded together and formed the Dutch East India Company to share the risks and the rewards of their conquests.

This is amongst the first examples of the modern corporation. The company brought back spices and reaped profits that went back into building more ships and sailing back to Asia. The company didn’t distribute the profits to individual shareholders who instead were issued the modern form of a share certificate for their ownership. Because they couldn’t monetize this ownership they started selling shares of their ownership to others, thus perhaps the first stock market and transaction dating back to the early 1600s.

No sooner did people start selling shares in these companies than market speculators started spreading false stories about merchant ships being sunk or about large spice conquests to drive up or down the price of these stocks through false information and manipulation. So oversight became necessary to establish trust in the value of these assets.


What Jamie Dimon got wrong about bitcoin and tulips

Mackay confused two distinct eras. He reports stories from around 1610 about high prices paid for individual bulbs. What he failed to realize is that people were not paying for single flowers, but for the entire breeding stock — or a significant portion of it — of popular new tulip varieties. People have continued to pay higher inflation-adjusted prices for new tulip and lily bulbs to this day.

A quarter century later, a futures market grew up around fractional interests in low-priced, ordinary tulip bulbs. In premodern Europe investment returns were very high, 20 percent or 30 percent per year on low risk investments, but laws and customs prevented anyone not in the merchant class from taking advantage.

Holland accidentally created a loophole by allowing contracts for fractional interests in tulip bulbs for the convenience of the industry. These were needed because the price of popular new bulbs was higher than even rich individuals could afford. In the early 1630s ordinary people discovered that these contracts could serve as money to support business and investment. These contracts then became “monetized,” as happens to all assets used as bases for monetary activity. That means their value decoupled from the use value of the underlying asset and became determined by demand for money services.

By 1637, contracts for fractional interests of low-priced tulip bulbs had risen to 20 times the price of the actual bulbs, reflecting the explosion of economic activity they stimulated. In February 1637, the market collapsed; six weeks later it was outlawed.


What Jamie Dimon is missing about Bitcoin

It’s no secret that Bitcoin and other digital currencies may dramatically fall in value at any time. How can an asset whose value jumps by 20 percent some days, and which no one can accurately value, plausibly not also suffer huge declines? But that’s a long way from Bitcoin being a worthless fraud.

Of course, fiat currencies like the dollar have the backing of a sovereign nation. Digital currencies are obviously far more speculative, have been around for only a few years, and don’t have a government’s underlying support. But almost all currencies today are conjured up from nothing — the euro didn’t even exist 20 years ago — and their value is largely dependent on trust.

His firm conjured up its own currency: Chase Ultimate Reward points, its credit card loyalty program. Millions of customers have accumulated billions of points, trusting in Chase’s promise that this currency can be converted into cash or used for travel and other delights. And they hope that Chase won’t unilaterally choose to devalue them…

But new use cases for digital currencies are just starting to take shape. They are now being used to create value in the way that Silicon Valley has traditionally done so: regulatory arbitrage. Ride-hailing got its start avoiding onerous taxi medallion costs; Airbnb avoided hotel taxes and regulations; and YouTube played fast and loose with copyright rules.