How Start-Ups And VCs Get Fooled By The Big Market Delusion

How does one avoid investing in a company like WeWork? Its original IPO valuation was $47bn but it ended up being valued closer to $14bn. The answer lies in understanding “the big market promise” argue Aswath Damodaran and Bradford Cornell in their new paper, The Big Market Delusion: Valuation and Investment Implications. It’s the promise of unbounded big markets that fuels the  overconfidence of entrepreneurs, venture capitalists and investors at large.

 

Starting Point: Entrepreneurs and Venture Capitalists Are “Irrationally” Overconfident

A critical component of these types of bubbles are the presence of entrepreneurs and venture capitalists, both are prone to higher levels of over-confidence than other market participants. For example, most tend think they better than the average entrepreneur or venture capitalist (not everyone can be better than average!) and they overstate how much control they have over outcomes. This shows up in data:

• 80% of entrepreneurs believe they have at least a 70% chance of succeeding. The reality is that 75% of start-ups fail.

• Surveys show that venture capitalists vastly overestimate the success of their investments and they often pass on investments in superior firms.

 

The Big Market Delusion

Now, if we throw these types of individuals towards opportunities that exploit apparent big market opportunities, then bubbles can start to form. The key ingredients are:

(1) The size of the market: As the target market gets bigger, more entrants appear. It gets worse if the size of the target market is unclear – leading to even more outlandish sales projections.

(2) Uncertainty: the more uncertainty about the business model and ability to convert them into revenues, the more overconfident these entrants become. A current example is AI – a big market with much uncertainty. It could work for everything or nothing.

(3) Winner-take-all-markets: the overpricing will be greatest where there are global networking or flywheel effects (growth feeds growth). Everyone will think their company will be the winner and will price them accordingly, yet only a handful can win.

 

Together this creates the big market delusion, and entrepreneurs/venture capitalists price such opportunities at the most extreme end. They also tend to rely less on fundamentals to value the company and more on what others are willing to pay. In a typical life cycle of a company, it is the start-up phase where there is most scope to value companies in this way (Chart 1). As the company matures, the actual size of the market (and competitive landscape) becomes apparent and a more sober perspective gets applied to valuations. This often means sharp corrections.

 

Figure 1: Price Versus Value – A Corporate Life Cycle Perspective

Source: The Big Market Delusion: Valuation and Investment Implications, pg. 10

 

 

3 Examples

The authors examine three case studies:

(1) eCommerce in the 1990s (dot com boom): Amazon, Paypal and eBay are the survivors from that period but most others have failed. The rise of the internet and rapid growth in online revenue in the 1990s fuelled the bubble. By 1999, 60% of all IPOs were internet stocks. But by the end of 2000, internet stocks suffered a 70% correction.

(2) Online Advertising. Online advertising exploded over the 2010s – Google, Facebook and social media in general were the poster boys, but there were hundreds of companies in the online advertising space. The market potential was expected to be very big. The authors estimate that at the height of the boom in 2015 – valuations suggested the total online ad revenue for the industry would grow to $532bn by 2025. Today, the two dominant players Facebook and Google deliver only $187bn of online ad revenue. Since 2015, markets have reduced their expectations, and it has been more gradual than the dot-com crash

(3) The Cannabis market. In 2018, smoking marijuana recreationally became legal in nine US states and using it medicinally in twenty states. The view was that as lots of people used cannabis and had the money to spend on it, the potential market would be huge. Estimates suggested that sales could reach $150bn by 2024. Therefore for the top listed cannabis companies despite their combined revenues only being $232mn, their combined valuation was $48bn (over 200 times revenue). But within a year, the stocks had fallen over 50 percent. This was due to the realisation that sales were not as rapid, many continued to use (cheaper) illegal marijuana and the high costs in developed medical marijuana.

 

Broadly speaking the greater and less concentrated capital is, the more quickly prices rise.

 

How to Cope with the Big Market Delusions

The authors argue that big market delusions are not always negative and can be necessary for a change in how we live, e.g. the dot com bubble. It altered not only how we shop but how we travel, plan and communicate with each other, but also some big companies like Amazon emerged from volatile times of market bubbles. Enthusiasm for big markets may lead to added price volatility, but it is also a spur for innovation. The benefits of the innovation may outweigh the costs of the volatility.

But for investors, it is trickier as there is no evidence we can time the collapse in these bubbles. All we can do is to identify the patterns for a big market delusion and then decide whether we go with it or against it. They summarise the key patterns as:

• Big market stories. Companies will talk about macro potential and the big market rather than business fundamentals

• Blindness to competition. The company will downplay competition – after all they will be the winner

• All about growth. Companies will flag user growth, sales growth and anything but profit growth

• Disconnect from fundamentals. Companies and VCs will price the company on non-fundamentals like number of users or clicks.

 

So, applying this to the current market – industries such as AI, meatless meat, office leasing, rental housing, ride sharing, fintech and video streaming all look to be suffering the big market delusion.