A network effect is the effect that one user or consumer has on the value of a product or service to other people. When this effect is present the value of the good or the service is dependent upon the number of people that use it. Find a company with a strong network effect and you will find a good company to invest your money in.
Warren Buffett, The Oracle of Omaha, has been known to say that he is always looking for "economic castles protected by unbreachable moats." That is, he wants to find companies with clear-cut competitive advantages that make them hard to duplicate and that allow them to be run well by average managers.
The idea of an economic moat changes over time as companies and industries evolve. What was yesterday's economic moat might be today's competitive disadvantage. In the era of Internet connectivity and online commerce, economic moats are synonymous with network effect.
Network effects become significant after critical mass has been achieved. Critical mass is the point at which the value obtained from the good or service is greater than the price paid for it. There are a really only two ways in which a company can obtain critical mass:
(1) via incentives - e.g., offering free products in exchange for signing up or offering referral fees
(2) via value creation - e.g., creating a network that offers value to its visitors so great that its visitors not only come back to the network but they invite others to come back as well.
A good example of an old network effect is the telephone. If one person had a telephone it was of no use to them. However, the more people that own telephones, the more valuable the telephone is to each owner and thus to the network as a whole.
In looking at Internet companies, its easy to make the comparison to the telephone network. Social network websites are perfect examples of companies with strong network effects. Early adopters take a liking to the site and invite others to use it. The network grows and eventually it creates a self-reinforcing loop whereby users come to the site because of the sheer size of the site and the amount of connections between users that it has, which creates additional value to the user.
With this in mind, I'd argue that it is wise to consider companies with strong network effects as companies with wide moats. In this regard, I would consider Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Yelp (NYSE:YELP), Zillow (NASDAQ:Z), Sina (NASDAQ:SINA), Google (NASDAQ:GOOG), Baidu (NASDAQ:BIDU) and YOKU (NYSE:YOKU) as companies with strong network effects. Each of these companies have a network of users that comes to their site for a variety of reasons but in large part because the network is so large that its size creates value for them. These are the companies of today with the economic moat that Warren Buffett has always talked about.
Of the companies listed about I believe the following are the best values relative to their current market caps.
Facebook is by far the best example of strong network effects. It boasts roughly 1 Billion users and many of those users spend up to 8 hours a day on the site. The beauty of the site is well known: people trust it because all of their friends are on the site and because they can stay in touch with people from far away. From an investors perspective, the beauty of Facebook is that it is able to tap into its massive user base to offer products and services quickly. A perfect example is its "Sponsored Stories" feature which was launched earlier this year. Within a couple of months it was doing a $1 Million Revenues per day run rate. Many analysts argue that they will be able to roll out things like product marketplaces (similar to Amazon quickly and be able to take commissions off every sale made in those marketplaces.
Google has roughly 3 billion searches per day. It is synonymous with search. The power of Google is that it can direct its visitors to related services that it will eventually generate revenues from. For example, its Google Shopping feature offers customers the ability to search for products by price or by keyword and find a variety of vendors offering those products. Google could eventually tap into this service as a revenue stream by offering a product marketplace and capturing transaction fees.
Zillow provides information related to homes, real estate listings, and mortgages that helps prospective buyers and renters of homes find their place to live. It also offers current home value and rental price estimates, called Zestimates, based on its proprietary valuation mechanism. In addition, the company provides advertising products and services comprising marketplace advertising services, such as agent programs and mortgage marketplace services.
The beauty of the Zillow business model is not that it is the largest online real estate listing service. It's that the brokers and mortgage providers on its site benefit from more users coming to the site. The more people that visit the site the more exposure brokers get to their listings and ultimately the higher the odds are that they can sell their listings or establish relationships with buyers and sellers of homes that they otherwise wouldn't have gotten exposure to.
Disclosure: I am long Z. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.