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Lessons from the extraordinary valuations of FAANGs

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30 July 2018
Point of view
Economic changes

Speech given (in French) on the occasion of the Xerfi conference "Transformation digitale et frénésie financière : l’entreprise, le travail et le capitalisme à l’ère numérique" on 5 April 2018.

The past fifteen years have witnessed a phenomenon that has had genuinely extraordinary consequences: the convergence of the world of finance and the world of global digital firms whose main economic feature is that they enjoy increasing returns (margins increase with volumes)...

Let's start with the facts. The seven biggest market capitalizations in the world are all firms that share these characteristics: Apple: $850 billion, Google (Alphabet): $720billion, Amazon: $700 billion, Microsoft: $680 billion, TenCent: $520 billion, Alibaba: $470 billion, Facebook: $460 billion.

Take the example of Amazon. The e-commerce giant currently has a market valuation of $700 billion, representing roughly 240 times its annual profits and four times its revenues.

In the world of conventional finance (i.e. that applying to firms experiencing decreasing returns), a company generating a profit of $3 billion could, depending on its growth prospects, be worth somewhere between $40 and $90 billion. But Amazon is valued at $700 billion.

This valuation is not a sign of irrational exuberance. On the contrary, nothing could be more rational in this convergence of finance and global firms enjoying increasing returns.

The process takes place in two stages:

  • Initially, the financier-investor provides the firm with the capital needed for its growth by reversing his usual operating procedure: instead of injecting 10 into a firm that is worth 100 in exchange for 10% of its capital, he will inject 10 into a firm in exchange for 10% of the capital and decide, as a consequence, that the firm is worth 100. In other words, while it was the enterprise value that determined the amount of funding in the conventional world, here the reasoning is reversed and it is the amount of funding that determines the enterprise value.
  • Subsequently, the investor values the firm that he has just financed at a level that is disconnected from the usual parameters: he is prepared to pay an extremely high price for a firm that is generating losses (e.g. Uber, which is not listed on the stock exchange, generated losses of $4.5 billion in 2017, while Spotify was recently floated on the stock exchange and has a valuation of $26 billion, with losses of $1.24 billion) or small profits (e.g. Amazon), because the only criterion that counts is the fastest possible development of a monopolistic business model in which the winner takes all. In so doing, the financier is rational because he is factoring in the self-fulfilling nature of this way of proceeding. Providing these enterprises with substantial resources at the time of their launch enables them to achieve their monopolistic global ambitions: it is not because they are monopolistic that these firms are highly valued, it is because they are highly valued as a result of the funding provided to them that they can become monopolies. Uber, for example, which is not listed on the stock exchange, has raised $13.5 billion so far and is estimated to be worth $51 billion.

At the same time, the "disproportionate" valuations of these firms provide them with a currency (their own stock) which enables them to buy up their competitors, themselves often overvalued, without it costing them anything. For example, Instagram was bought by Facebook in 2012 for $1 billion when it had existed for only two years and had 13 employees. These valuations also 

provide them with extraordinary power in their commercial relations. These two phenomena also contribute, of course, to establishing the monopoly they are targeting.

Economists call someone who establishes or promotes the establishment of a monopoly a "monopolist". It is clear that, in this convergence of finance and the world of companies with increasing returns, the financier-investor becomes a monopolist: by his action he creates monopolies which tomorrow will provide him with quite extraordinary opportunities of capital gains or profits.

However, although this way of expanding is rational for the companies in question and for their financiers, it is not without consequences for the rest of the economy.

Let us go back to the example of Amazon:

The development of a monopoly is considered harmful for the functioning of an economy based on competition. This, as we know, is why the anti-trust authorities monitor the establishment of monopolies, oligopolies and cartels, and regularly intervene by means of sanctions or, at least in the past, went as far as dismantling firms that had become monopolistic.

The key question, in this specific case, is therefore to consider whether Amazon benefits consumers or not. And the answer to this question depends on the person you ask:

  • Amazon and its advocates explain, in line with the facts observed at present, that the firm practises low prices which benefit consumers. Based on this observation, they conclude that this is a non-issue for anti-trust authorities.
  • But the stock exchange, whose function is to transform expectations of future margins and profits into prices, tells quite a different story: that of a monopolistic giant which must boost its margins by a large multiple in order to someday justify its market valuation. Investors value Amazon as a monopoly in a position to force its prices on consumers in the future.

So the dilemma is as follows:

  1. If there are really no grounds to fear that Amazon may someday act against consumers' interests as a result of its monopoly position, then Amazon's current market valuation is unjustified and should be divided by 10.
  2. If, on the other hand, the stock market is right to value Amazon at $700 billion, then it is blatantly obvious that the practices of this monopolistic firm will in future be harmful to consumers' interests and the anti-trust authorities should be looking into it.

In short, Amazon's share price tells us two things:

  • First, that the firm is in the process of building a monopoly and that it will raise its prices significantly once this monopoly has been completely established.
  • Second, that investors do not believe in a reaction by anti-trust authorities.

But while the debate on the detrimental effects of monopolies generally focuses on consumers, the real economy is already suffering from the development of these monopolies due to the resultant stifling of innovation.

For example, it has now become extremely difficult to raise venture capital funding for an e-commerce initiative because the place has already been taken by Amazon, or by Alibaba in the Asia-Pacific region. In light of current trends, future e-commerce companies will be doomed to be stifled or, in the best of cases, subjugated by becoming subcontracting members of the Amazon or Alibaba platforms and, in so doing, sharing their data. This, in a context where, as we know, data is the main source of value in the digital world.

By its spin-off effects, it is clear that the inflated valuation of the digital giants is already crushing competition, innovation and entrepreneurship, and that it will be detrimental to consumers in the future.

When he invests in a firm with increasing returns, the financier becomes a monopolist and this adversely affects the proper functioning of the economy.

The anti-trust authorities should perhaps listen to what share prices are telling them.

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