Posted in Finance Articles, Total Reads: 1260
, Published on 15 November 2012
It hasn’t been long since Facebook went public amid much fanfare, few predicting astronomical returns for anyone who could get a bite of this pie, and few others sceptically dismissing this as one of those dotcom mistakes that many fell prey to a few years ago. So which one of them is true? Well it’s too early to say anything. It has been just 6 months (FB got listed on May 17, 2012), and for a company boasting to be worth $ 100 Billion (at one point of time before the IPO), this is a very short span of time to predict anything. However, the events that have transpired in the last few days do bring to attention some of the important aspects of the social networking stocks.
And when I say social networking, I am not just referring to Facebook. I am referring to even stocks like Zynga (an online gaming company) or Vringo (an app development firm targeting mobile social networking platforms). The dynamics of these stocks are not the same as that of say P&G or Boeing. Hence these stocks require much closer attention when investing and that’s the reason behind writing this article. I don’t want to get into a complex analysis of these stocks but instead will carry out a simple demand-utility analysis to get some insights into their dynamics and predict some of the investment strategies.
LIFE CYCLE OF A “SOCIAL” STOCK:
All social networking stocks have a life cycle. Below are the three major stages in the life of the stock their characteristics:
1) Janma (Sanskrit word for Birth): This is when a social networking site is setup. These are the early stages of the site. The site is new and has a very low user base. As a result, the revenues are pretty low or almost nil as these stocks mainly derive most of their revenues from advertising which is again directly related to the user base.
From an investor’s perspective, this is a stage of high risk. An investment at this stage can either earn millions for you or all your investment might go down the drain. An investment at this stage is usually funded by VC’s who have a high risk appetite.
2) Vriddhi (Sanskrit word for growth): If the website can survive the initial acid test and starts sustaining and growing, then it enters the stage which I call the “Vriddhi” stage. The site starts expanding its user base and because of that advertising revenues also gradually increase. The growth from this stage depends on the marketing strategy adopted by the site.
From an investor’s perspective this is a relatively safer period for investing in the stock. The returns may not be as high as in the case of “Janma” stage but it will still yield good returns based on the growth of the firm.
3) Jara (Sanskrit for Old age): This is the final stage in the life of the firm from an investor’s perspective. By this time the user base of the firm usually reaches saturation. The existing users are also pretty much fed up with the services provided by the website. They are used to it and everything has become pretty much repetitive and boring. People start yearning for some new stuff. This is when rival websites swoop in and try to attract the existing customers. Even if the market fails to offer competition and the website maintains a virtual monopoly, it’s pretty much certain that the customer base will not expand substantially hereafter. There are only two things that can happen from here onwards, either the firm will continue operating at the current revenue levels or will eventually collapse.
From an investor’s perspective, this is the right time to sell his/her positions in the stock. There is usually no returning from this stage and the user base either becomes stagnant or starts dwindling. Hence investors cannot expect any increases in share value from this point.
Now I will perform a simple analysis based on Utility and demand curves. This can be used as a framework for performing any further analysis of specific stocks.
UTILITY AND DEMAND ANALYSIS:
Before I get started with the analysis let me just clarify a few terms.
Demand: Here the “quantity of the website demanded” is nothing but the amount of time spent by the user on the website. Hence, this quantity is a function of the amount of time spent using the website.
Where Ts is the amount of time spent using the website.
Utility: The utility in this case means the pleasure derived by a person using these sites. The pleasure can be derived by getting in touch with friends/family, sharing photos, chatting etc. Hence it can be safely assumed that the utility is a function of time spent on the website.
Here Qd is a function of the amount of time spent on the website.
Price: The price in this case is the opportunity cost of spending time on these sites. It has been estimated that the world loses billions of dollars every year because of people wasting their time on sites such as Facebook and twitter. Hence it definitely makes sense for us to consider this as the price incurred by the user as he could otherwise use this time to do something worthwhile and earn money out of it. Also, again, it can be safely assumed that this opportunity cost is a function of the amount of time spent on using the website.
SHORT-RUN ANALYSIS OF THE USER BEHAVIOUR:
The demand for the website increases in the short run for a particular user. The reason for this is that the utility of the website also increases in the short run. Hence it’s natural for the user to demand more. But, the utility increases with a decreasing rate and the utility curve flattens after some time as shown on the next page. This is in accordance with the decreasing marginal utility of the product.
Consider the quantity demanded to be given by the linear equation
Here “a” is a constant.
Then the utility is given by the equation
U= (aTs)^((1/k) )…………Eqn 5
Here K is a constant that depends on a lot of factors such as the features provided by the website etc. that keeps the users engaged and loyal to this particular website.
If a website wants to keep increasing the utility of the website for the consumers then it needs to keep the value of “k” as small as possible for which it needs to keep adding new features to the website.
From equation 3 price is a function of quantity demanded. For simplicity of analysis if we consider a linear relationship between the price and quantity demanded, then combining equations 3 and 4 we get
Here “m” is a constant.
From this equation we see that the demand curve for the product is as shown in figure 2. As is evident from the demand curve the website here is behaving like a Giffen good. The important parameter to note here is P_threshold parameter. This is the maximum price that a consumer is willing to pay to spend time on the website. After this the user is no more willing to waste time on the website. This is also the point where the marginal utility from spending more time on the website drops to zero. Also another important parameter to note here is Qmax, as this is the maximum quantity upto which the total utility of the consumer keeps increasing. I am not saying that the total time spent by the user on social networking sites will reduce; he/she may just switch to some other website (to which the user is relatively new). But the usage on that particular website is surely going to come down.
LONG-RUN ANALYSIS OF THE USER BEHAVIOUR:
From the short-run analysis it’s quite clear that the user will stop consuming any quantity beyond Qmax as this does not increase his utility. Also one of the reasons the user is not willing to spend more of his time is because of the inability of the website to come up with newer and more innovative products which will keep the user engaged. But the important thing to note here is that the consumption level does not remain constant at Qmax. Once the user reaches this consumption level his consumption again starts reducing. This could be because of various reasons such as the user switching to another website or the user realising that he is just wasting his time by spending it on the website. So any website that enters its “Jara” phase will see the users behaving in similar fashion.
Hence, when a website enters its “Jara” phase the utility function of the website for a particular user changes and assumes the shape shown in figure 3. As shown in the figure, the
utility of the user increases as he reduces his consumption until it again reaches a saturation point beyond which the reduction in the consumption does not yield any improvement in the utility levels. Here the user reduces his consumption till he reaches a point where the price of spending time on the website reduces to P_longterm. This is the minimum long term cost of spending time on the website. However, during the course of website usage, the user will might keep changing his consumption levels such that the price remains range bounded between P_longterm and P_threshold . As an approximation we can say that the average cost of spending time on the website is given by:
Pavg= (P_longterm+ P_threshold)1/2………………Eqn 7
However, this is a very crude approximation of the average price as the pattern of usage can assume various shapes within this range.
PUTTING IT ALL IN CONTEXT:
Having developed the short-run and long-run utility and demand curves, I will correlate them to the three stages of the stock’s life. During the 1st two stages of the stocks life, i.e. “Janma” and “Vriddhi” we see an upward trend in the utility curve and a spike in the demand due to the increasing utility. However, towards the end of “Vriddhi” the utility curve flattens and the marginal utility falls to almost zero.
When the stock enters the “Jara” phase, there is a change in the stock price movement. Now there is a reversal in the utility curve of the stock. Reducing the usage of the website now increases the utility of the users as the time saved can be used for better purposes. This reduces the price equivalence of the time wasted on these websites to P_longterm . In the long term the average price spent on spending time on the websites is governed by equation 7.
FACEBOOK-A CASE STUDY:
All the concepts given above can be applied to the case of Facebook. In this section, I will try to analyse the stock performance of Facebook keeping in view the model developed above.
The shares of Facebook are down almost 50% since they got listed and analysts have been wondering as to what are the reasons. The reasons are pretty much evident from the above model. Currently Facebook’s stock is in its “Vriddhi” phase but is almost heading towards the “Jara” phase. The number of users has almost reached saturation. The product range has also been limited and Facebook is not able to come up with any innovative products. If Facebook wants to avoid entering its “Jara” phase then it needs to decrease its “k” value as soon as possible in accordance with equation 5.
However, this definitely doesn’t mean that Facebook will soon shut down. It just means that investors will not be able to reap benefits from this stock by entering in this stage. The stock is unlikely to see any value growth unless it takes the necessary steps mentioned earlier.
Investors should exercise extreme caution while investing in social networking stocks. One can earn profits only by getting the timing right and by investing during the “Janma” and “Vriddhi” stages. But before investing in these stages one should carefully analyse his risk appetite. If one does not wish to take such risks then it’s better to stay away from the stocks of social networking companies. But like I stressed earlier also none of this analysis says that the social networking companies will shut down after they reach the “Jara” phase. These stocks have had some extremely positive impacts on societies around the world and have made the world a smaller place. No one can deny the importance of websites such as Facebook and Twitter in today’s world and no one wants to see them close down (except their competitors). Long live Social Networking!!!!
1) Microeconomics, 8th edition, The Pearson series in economics, Robert S. Pindyck and Daniel L. Rubinfeld.