How much are users worth?
Public Domain. Source: Dreamstime
Amazon has Prime, Netflix has subscribers, and Limebike has riders. Each of these companies has a user-base that loves its service, and creates value for the firm that manages it. But what is the basis for this value? What makes some user-bases profitable, while others – like newspaper subscriptions – seem to wither away and die?
It goes back to the fundamentals of finance. The value of any asset is based on its cashflows, growth, and risk. A fast-growing user-base is good; one that generates strong revenues is better; and if those revenues are stable and resilient to cyclical ups and downs in the economy, that’s better still. Financial analysts used to call this the “lipstick indicator”: even when times are hard, people shop for lipstick, an affordable indulgence. And having brand loyalty means never having to say you’re sorry about a stupid idea or a bad color.
But there are good, bad, and ugly user-based business models. Investors have to consider costs. Costs can be like barnacles on the hull of a ship, keeping the value and valuation low. But costs can be an engine of growth. It’s far better for a young company to spend money to acquire new users than to lose money because servicing existing users is too expensive. That’s one reason Moviepass isn’t working: it’s too good to be true. Eight dollars per month for unlimited movie-going is just too cheap. But if you raise the price to a profitable level, users just drop off. They aren’t sticky.
If you have an economic user base, there are three ways to make money: sell products and services (Uber), sell subscriptions (Netflix), or sell ads (Yelp, Facebook). Amazon Prime is a hybrid, a subscription that also sells products. Subscriptions tend to be sticky: people pre-committed their cash and want their money’s worth. Advertisers can scale up faster, since users are free. But they’re data-driven and depend on user-intensity. That’s why aggregators like Google, Facebook, and Yelp all fight for the same eyeballs. Selling products and services is the riskiest, since every sale depends on the user’s last experience. People can stop buying at any time, and word-of-mouth means network effects can run in reverse.
Limebike depends on network effects. Source: Limebike
Every business’s value depends on how efficiently it can generate a sustainable, growing stream of free cash from its customers. Whether they measure page-views or daily active users or tweets or letters to the editor, investors need to understand the iron law of all user-based businesses: users must be weighed, not counted.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”