Digital companies are becoming more common every year. Ten years ago, there was no such thing as Social Media and online shopping was barely used. Now, digital companies are the base of our network and our purchasing behavior. Especially Social Media networks like Facebook and Twitter have created a large customer base and you can probably not imagine your life without them.
The popularity of these digital companies are recognizable on their stock trends. Within 5 years, the stock of Facebook has increase over 10-fold, making the value of the company large. But where does it value come from? When you look at the balance sheet of digital companies, you will see that the company does not own a lot of tangible assets. Twitter has even reported its first (small) profit ever this year (Fiegerman, 2019). We have learned that the value of these digital businesses is party from the creation of Network Effects, the value of a product or service assigned by the user. The value increases according to the number of users. Basically, you are betting your money on a company that does not have (enough) resources and that therefore not able to cover costs if these shares will fall.
Research has shown that only 2.4% of investment decisions are based on a companies’ income statement. Where would the decision come from? You can look at the investments that are made or ongoing projects the company is working on, these are both factors that digital companies do not really have. The value of a digital company is assigned by the users. For me, this is comparable to a cryptocurrency; the value is determined by the public and the value of the currency can drop whenever the public thinks that the company does not have this value anymore. The same thing can happen with any digital company. As they do not have a lot of tangible value, their value completely depends on the the value that their investors and users assign to the company and its network. So why do people warn you not to invest in cryptocurrencies, but advice you to invest in digital companies? Is it naïve of us to do this? Or are there other differences that can explain the different views on these investments?
Fiegerman (2019), ‘Twitter records its first annual profit, but it is losing millions of users’. CNN Business. Available at: https://edition.cnn.com/2019/02/07/tech/twitter-earnings-q4/index.html
Hi Rixt! I think you got a really nice point there. I did some more research online and I found that there was a Dot-com bubble that bursted around the 20th century. When internet companies were launched, investors assumed that these companies were going to be worth a lot. This led to an overvaluation of many companies, as not all companies could succeed. Valuation back then was also focused on the ‘network theory’, stating that more computers hosting the website would increase hte companies value exponentially. However, they didn’t look at how the company was actually able to make use of the network to generate profits. Thus, many of these high-valued companies crashed.
Some sources say that there could be another ‘Internet/tech bubble’ now. As you said, digital companies that enjoy network effects, such as Twitter and Facebook, are valued highly. However, their profits are not in proportion with the profits they make. Furthermore, if switching costs for users are low, it is easy for them to switch between companies that offer the same service. As a result, it is difficult as a company to ask more from your users. If they don’t like it, they will simply leave. What will happen is of course uncertain, but it’s interesting to think about!
https://www.moneycrashers.com/dot-com-bubble-burst/
https://theconversation.com/why-2019-could-be-the-year-of-another-tech-bubble-crash-109468