The Online Advertising Market
Broken down by geography, I can add to that story:
The basis for the macro story being told about social media companies is visible in this graph. Advertising is growing as a business, driven by growth in emerging markets, and an increasing proportion of the revenues comes online. The biggest losers are newspapers and magazines, but television and other conventional outlets (radio, cinema & outdoor) have held up surprisingly well under the online assault. The prediction is that this shift to online advertising will continue into the future, though the rate of growth will slow down as online advertising becomes a larger and larger slice of total advertising. In the table below, I look at expected online advertising revenues (in billions of U.S. dollars) in 2023, with different assumptions about annual growth in the market and the online share of that market.
Thus, in the optimistic scenario for online ad spending, I assume that it continues to gain market share at the same rate as it did between 2011 and 2013 (to get from 19.83% today to 40% in 2023) and that ad spending grows at 4% a year for the next decade and arrive at a value of $303.04 billion in spending on online advertising in 2023.
Imputed Future Revenues in Market Values
I used this spreadsheet, with standardized numbers (cost of capital of 10%, sales to capital ratio of 1.50 and a target operating margin of 25% for most of the companies, to get imputed revenues for all of the publicly traded companies in my social media list. The table below summarizes the imputed revenues for an incomplete list of companies that derive their revenues from online advertising, with four large non-U.S. companies thrown into the mix.
All of the break even DCFs are available in this folder. It is true that not all of the revenues at each of these companies is from online advertising. Using the most recent annual reports, I estimated the percentage of overall revenues from advertising and backed out the portion of the imputed online advertising revenues keeping that percentage unchanged. If you add up the imputed revenues across companies, the total online advertising revenue across just these companies is $319.2 billion, higher than my estimate of the overall online advertising market in 2023. Note that I erred on the conservative side in my assumptions to generate lower imputed revenues; shifting to a 12% cost of capital for all companies increases imputed revenues in 2023 to over $400 billion, as does using a target operating margin of 20%. Given that there are other online advertisers that have not been counted in this list, that there are a whole host of private companies like Pinterest and Snapchat waiting in the wings, ready to go public, and still more brewing in the fertile imaginations of creative people somewhere, it is safe to say that the market collectively has a macro problem that is difficult to explain away.
- Social media companies are collectively over valued: As in other young sector booms - PC companies in the 1980s, dot-com companies in the 1990s - the market seems to be getting the macro story right but the micro valuations wrong. Diversification as a strategy may be a good one in sectors where the law of large numbers work in your favor, but not in sectors like social media, where you have "bias upwards" in the valuations. A social media ETF may be a good momentum play but it is unlikely to be a good investment.
- One or two of them will be the winners over the next decade: If you are an investor with a social media company in your portfolio, is that investment doomed? Not necessarily, because while these companies may be collectively over valued, there will be winners among these companies that will emerge as the sector matures. Using the dot-com sector as the template again, an investor in Amazon (AMZN) even at the peak of the boom in January 2000 would have little to complain about today. The key to investment success in this sector then becomes tagging the winners early in the process. While Google and Facebook (FB) are the early leaders in this race, those standings will change as technology and customer behavior change over time.
- The valuations may be put at risk if entry into this business is “easy”: The PC business from the 1980s should offer a cautionary note for investors who assume that a market that is growing fast will also deliver high value to investors in companies in that market. If the barriers to entry are low, you can have high revenue growth in conjunction with low margins and little value creation.
What can investors do?
- Less macro story telling: As investors, we should be wary of story tellers, who use the same macro argument (the online ad market is getting bigger, there are a billion people in China) to justify one company valuation after another. Stories are a useful starting point but they have to be linked to specifics.
- Longer time horizons: While I understand the desire of analysts to frame their assessment of companies around the near term (next quarter’s earnings, next year’s revenues), you have to attempt to look at where the firm will end up over the long term. (I use ten years, but it does not have to be that long). It is tough to introduce any macro discipline in your thinking with short time horizons.
- Winner and Losers: If we start off with the presumption that the pie, defined broadly (as advertising and not online advertising), is limited, high revenue growth for one company often has to come from competitors and it behooves us to be explicit about winners and losers. For instance, in my Twitter (TWTR) valuation, where I estimate revenues will grow from $448 million right now to $11 billion in 2023, I should have tried to explain how much of this additional revenue will come from old-world media (newspapers, magazines, cinema), how much from other online advertisers (Google, Facebook) and how much from growth in the market.
- Transparency: While revenue growth and operating margins are both critical inputs into valuation, they are interconnected and often require that you look at trade offs. Thus, going for higher revenue growth will generally mean lower operating margins and the net effect can be positive or negative.
It is easy to develop tunnel vision when valuing companies and forget that the rest of the world does not remain static, while the company being valued plots its path to success. Unless we consciously step back and look at the big picture, we will continue to create micro valuations that don't up aggregate to create viable macro environments.